Believe in the power of Moving Averages!

While no technical indicator is perfect, or gives totally accurate signals, moving averages can provide reliable zones of support and resistance in trending markets.

Today is a unique day in the Dow Index, in that the market tested both the lower 2o period MA (for support) and the flat 50 period MA for resistance.

 

 As technicians, we say “the market is trapped between its moving averages” and imply that a breakout of the “trapped zone” must occur.  At the moment, this signals indecision and no clear direction (at least temporarily).  It is good for the market to pause after rapid mark-ups or mark-downs (recently).

If you don’t use moving averages, or don’t know how to optimize moving averages (which settings work best), then studying how price reacts when it approaches a key moving average can be a very valuable exercise for you.

I live by moving averages for various confirmation or trade entries (or stop placements) and have found the 20 period exponential, 50 period exponential (or simple, depending on preference) and the 200 period (daily) simple work the best.  Feel free to add your own comments if you find others to work.  Many people use shorter moving averages and also use them as signals of trend strength.

However you use them, always know key areas on chart time frames higher than the one on which you are trading.  Post (or interlay) higher time frame moving averages onto lower time frame charts and see how the market trades around these levels.  Often, key tests of moving averages in trending environments (view the left side of the chart) serve as entry points into a trend.

Nevertheless, it is odd that the market (Dow Jones Index) tested both moving averages to the penny today, and I wanted to bring this to your attention.

Today was an active day in the equity markets!  The news of the day was Chairman Bernake’s testimony which rattled investors early this morning.  Remember, news is difficult to predict, but the momentum action creates a predictable trade idea with high probabilities of success.  Today was no different.  We had a test of the most recent swing-low just after the retracement after the new momentum and price low made early which set up an “Impulse Sell” trade.

Also, note the divergence trades which could have been aggressively entered both on the long and the short side of the market.

Today’s plays were most profitable from a “Momentum Divergence” standpoint.  In other words, even though price looked grim, momentum that underlined the price showed a different story.

 The arrows indicate Impulse Buys or Impulse Sells which both would have achieved the objective (most recent swing high only).  I did not annotate the “divergence” plays which would have yielded more profit, actually.  Remember, divergence trades are entered when price makes a new low (or tests a recent low) yet momentum (compared to the price swing) makes a higher low.  The trade is entered when you view this divergence and you must keep a tight stop.  The target is just beyond the most recent swing high or low, and the trade is played for a scalp only, not a trend change.

Let it be noted that today’s play is working out from a newly initiated lower swing on the daily charts, and so the bias for the day should have been to the short side.  Swing traders should have already entered a short position when the market was recently overextended to the upside and ready for a corrective swing down to begin.

Always analyze higher time frames to determine market structure and swing patterns before entering the day-trading and scalping arena.  Let this ‘bias’ guide your trades for the day and manage risk.

Dr. Brett Steenbarger posted a timely analysis entitled Traders and Information Processing:  Why Traders Sabotage Themselves.

This post is an absolute read.  His concluding post reads:

“Trading problems begin when we  enter trades by one information processing system, and manage them by another.”

To see what he means and learn his insights, visit the post or his blog at TraderFeed. 

Today provided a great example of how one day, your system will work and the next day, the system does not. Nevertheless, the insight is that it is crucial to follow your system, rather than take random trades and achieve random results. Compare the 15 minute charts of yesterday and today.

While I trade with more complex information than I simplify here, assume that our system is to take trades in the direction of the market breadth (negative for both days) and (in this case) enter short when price rallies back to the 20 period moving average. Stop is placed beyond the 50 period moving average (or include time stop component). The target is the most recent price swing low.

If this is the case, then four trades occurred (red arrows). The first was stopped out. This could lead to frustration and could cause you to pass on the next opportunity (signal) from your system which occurred the next day (today).

The next two trades were perfect, textbook winners. No rinse, no wash, no gimmics. But what if you passed on these trades, as many of us are so likely to do?

The fourth signal occurred late in the day and maybe you decided to take it because you see the system working now. The outcome of this trade is a scratch, as the trade must be closed prior to the close. The trade could be closed with a slight profit, but the target was not achieved.

Also note that price nicked just above the moving average, and if your stop was too close, you would have been rinsed right before the intended move.

Market Psychology Insight!

We have our own way of determining when to enter a trade and where to place a stop, yet our emotions and past experience influence this greatly. As discretionary traders, we have great leeway about how to make these decisions. If we have a proper, established framework, it can become difficult to execute flawlessly because no system is 100% perfect; all systems will have losses (usually to the tune of 50%, which is pure chance).

What happens when we take a signal and it results in a stop-loss? We are less likely to take the next signal.

What happens when we avoid a signal that turned out to be a winner? We are more likely to take the next signal.

In probability theory, avoiding trades doesn’t make logical sense. This is another example of how our emotions influence how we trade, with the result being sub-par results. If you have a system with an edge, you must commit yourself to taking ALL the trades it offers. Doing so keeps the thinking and emotion to a minimum, while statistics and the odds play out in your favor over time.

(Market Education Hint: Notice the possible momentum divergence developing. Price also seems to be establishing temporary equilibrium.)

I wanted to highlight a personal post redarding a recent stop-loss experience from the 59 Cedar Street blog, which personifies experiences I have had, and I know we all have had.

BP references the fear once in a trade and the almost compelling notion to move your stop to break-even once profit is achieved. I have done this so many times and often ended with the same result as BP – a scratched trade on a possibility that would have achieved or exceeded my target.

Not only does he post the experience, he posts the lesson he learned from it, and with this realization, he can evaluate how to “take the heat” a little longer and fight the urge to avoid pain by killing a trade early.

The post is definately worth reading, as he explores his thinking and how fear tends to cost us in the market (or as Mark Douglas says, we tend to create the result – losses – that we are fearing).