The TradersWire Guide To Combining Moving Averages and Retracements
By Duke Heberlein
Converge: (1) To tend to meet in a point or line; incline towards one another, as lines which are not parallel. (2) To tend to a common result, conclusion, etc.
As traders, our main objective is not to be right in our assessment of where the market as a whole may be heading, but rather to find the best stocks that will give us the greatest probability of rewarding us with a profit. Keeping that in mind, how does one go about finding, in the words of oilman J. Paul Getty, “where the oil is?”
One my best techniques for uncovering both day trades and swing trades is to: (1) Focus on stocks that have been performing in the top 20% of the market overall for long candidates, and the bottom 20% to spot potential shorts, and (2) look for convergence of either the 20- or the 50-day moving average with a major Fibonacci retracement level. Ideally, when you can combine all of these factors with a pattern, the stage is set for an observant speculator to add to his or her bottom line.
Stock Selection
One of the most important facets in the success of any trader is stock selection. If you are going to succeed as a trader by capturing intraday momentum and short-term swings, you must be stalking stocks that are moving. A simplistic statement, perhaps, but easily forgotten.
One of the strategies I like to use to look for the best chances of finding potential winners on a daily basis is, in addition to following the Nasdaq and NYSE big caps, bellwethers, and glamour stocks, is to use the TradingMarkets.com Stock Scanner to add the stocks to my watch list that have:
Demonstrated recent price strength in the top 20% of stocks in the market overall, by searching for those with a 3-month relative strength reading of 80 or higher. For shorting candidates, I search for stocks with a 3-month rank of 20 or lower, exhibiting that they have underperformed the rest of the equities market for the recent time period.
or,
Are showing a strong trend, either up or down, via an ADX reading of at least 30. Since ADX measures the strength of the trend only, we use the DMI (Directional Movement Indicator), to tell us the direction of the trend.
The final parameters I use for my screening in this approach is:
Price – In most instances I like to look for stocks with a price of at least $30 per share, based on the fact that higher priced stocks most of the time have greater intraday ranges and ease of movement. For a $60 stock to make a 3 point jump requires only a 5% move. For a $5 stock to make the same point move demands that it move 60%.
Volume – I screen for a 50-day average daily volume of at least 300,000 shares . This ensures me of enough liquidity to exit the trade without getting hit with the the wide spreads between the bid/ask that can occur in thinly traded issues.
Inputs for the Stock Scanner to scan for stocks with a 3-month RS ranking of 80 or higher, price $30 or higher and average daily volume of at least 300,000 shares. Note: when scanning for volume you must drop the last two zeros. To get possible stocks for shorting, in the RS (3 MO) boxes simply input 1 and 20.
Inputs for the Stock Scanner to scan for stocks with an ADX reading of 30 or higher, price over $30 and volume of at least 300,000 shares. In the readout from the results of the scan, you will see a “U” for an uptrending DMI and a “D” for a downtrending DMI.
Using moving averages with retracements to spot trades
Simple 20- and 50-day moving averages in trending stocks will many times provide springboards for stocks when they come down (or up if the stock is in a downtrend), hit the MA and then follow through to the upside from these levels. What is important to keep in mind is that the hitting of the MA alone is not what is important, but rather how the stock has performed in the past when encountering it.
The trade has a greater probability of becoming profitable if it meets up with an important retracement level, and when both of these are combined with an area of support or a technical pattern, that is the ideal.
BJ Services (BJS), shows a good example of this in the chart above. The stock retraced 50% of the move higher, encountering the 50-day moving average. From there it began a string of five higher highs. It then proceeded to pull back into another retracement, stopping just short of the 50% level and rebounding from the 20-day moving average and providing the swing trader with a good measured move of 10 points from 70-80. Even a trader who made the connection on BJS a bit late could have still snared a nice profit when the issue broke out of the inverted mini head and shoulders on January 24. Daytraders who were keeping watch on BJS found gold the following day.
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BJS after breaking out from the slim jim continues to thrust, pause, and continue into the close.
This type of action exhibits itself over and over with these two moving averages and the 38.2, 50 and 61.8% retracement levels.
Chico’s FAS (CHCS) rebounds off the converging MA’s and the 38.2% retracement of the move higher. Swing traders could place an initial protective stop at the low at the RT level. It is never touched and the trader can exit on the first pullback, trail it or continue to play it as a position trade by loosening the trailing stops a little, but continuing to trail it.
Homestore.com (HOMS) goes on the screen after a scan of the chart shows a bounce off the 50-day MA and the 50% retracement of the leg higher. Following the spike higher the stock retreats to consolidate along the 38.2% of the same upward move and the 20-day moving average. When the stock makes a wide-range bar that closes in the upper part of the range, we are on watch fro continuation. We are rewarded for our diligence with a 5+ point move in two days.
Alexion Pharmaceuticals (ALXN) shows how this technique works just as well to the downside. The stock takes a downturn, retraces a portion of that leg to the 38.2 % RT and the 20-day MA and attempts to mount a rally through the 20-day before failing and resuming its downtrend. Making note of this test and failure, when ALXN blows through the longer-term 38.2% retracement and the 50-day MA we continue to observe ALXN for similar price behavior. Sure enough, after hitting the 50% RT not far above the 50-day MA, it goes into free-fall, dropping more than 30 points in four sessions.
This is a strategy that works well on an intraday basis as well. Newport (NEWP) is in a downtrend on the daily chart, so we are monitoring for possible entry points in the direction of the trend in the intraday time frame. After a surge during Friday’s big down open, the stock begins to turn over. When it retraces to the 38.2% RT of the move down from the high, hits the 20-period MA and forms a consolidation along these technical levels, we are looking to go short in the direction of the overall market dynamics and the stock’s daily trend. NEWP falls 3 points in the next 40 minutes.
The short-term trader, whether on a strictly intraday base or playing one to five day swings, will benefit a great deal from following the stocks with these characteristics and monitoring them for this type of action. By narrowing the list down with the use of the Stock Scanner, one can easily scan the charts for trending stocks that are setting up both to the long and the short side. When convergence of the moving average, retracement and pattern come together, having a head start by doing your homework can pay off handsomely
