Today’s Trading Lesson From TradingMarkets
Editor’s Note:
Each night we feature a different lesson from
TM University. I hope you enjoy and profit from these.
E-mail me if you have
any questions.
Brice
Moving Averages:
Four Useful Strategies
In this third and
final installment on moving averages, we will look at more specific trading
methods that seek to capitalize on their inherent features.
Running Cup and Handle
The cup-and-handle (1) is typically a major reversal pattern that often
precedes large rallies. It is formed when a stock sells off, bottoms, and then
begins to rally, creating a “cup.” After the rally, the stock drifts lower,
forming the “handle” of the pattern. According to William O’Neil, who
popularized the pattern, the best cup-and-handle candidates are stocks that
already have staged a strong rally.
One way to measure the “strong rally†would be to use the 50-day moving
average. As long as a stock remains above the 50-day moving average, it can be
considered to be in an intermediate-term uptrend. Therefore, cup-and-handles
that formed at or above the 50-day moving average are dubbed “running†as the
market continues to “run†while the pattern is formed. The theory is that it
combines a bottoming/correction formation with trend — the best of both worlds.
Chart 1: Running Cup and Handle. Notice
the cup forms at and above the 50-day moving average. Source: The
TradingMarkets.com Guide to Conquering the Markets.
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Expansion Pivots
As mentioned above and in previous articles, the 50-day simple moving average
provides a point of reference for many institutions and large traders. Jeff
Cooper has observed that “a stock will trade around its 50-day moving average
for a period of time, and then without warning explode either to the upside or
downside. This explosion often follows through for at least a few days…â€(2). His
strategy looks for a wide-range day that occurs in a stock that is trading at
its 50-day moving average and then seeks to enter a position in the direction of
that expansion.
Chart 2: Expansion Pivots. This set-up looks to enter on follow-through after
wide-range movements at the 50-day moving average.
Holy Grail
In Street Smarts(3), Connors and Raschke showed that strongly-trending
markets often retrace to the moving average before re-asserting themselves. If
you think about it, this makes sense as markets often thrust/correct and then
thrust again — similar to the pullback pattern. Essentially the set-up looks
for a strongly-trending market as measured by high ADX followed by a retracement
to the 20-period exponential moving average. They jokingly dubbed this pattern
the “Holy Grailâ€.
Chart 3: The Holy Grail. The pattern seeks to capitalize on a resumption of a
strong trend as measured by a high ADX reading after retracements to the moving
average.
Daylight Breakouts
Often, markets will trade around the moving average. They will have a slight
rally (or selloff) and then return to the moving average. This is known as
reversion to the mean (average) and has been discussed in previous articles. On
occasion, the market will break free and begin to trend away from the moving
average. While looking for a long-term trend-following system for the
commodities markets, I notice that these trends or breakouts from the moving
averages are often preceded by a period of at least two days, where the lows
(for uptrends) or highs (for downtrends) fail to touch the moving average. This
“gap†above and below the moving average was dubbed “daylight†by a fellow
trader as you could see “daylight†in-between the price bar and the moving
average. The original system, The 2/20-Day EMA Breakout System(3), used a
20-day exponential moving average and is described below in figure 1. Once the
entry qualifications were met, a buy entry was placed above the two-bar high.
Short sales are reversed. Setups for the pattern are shown in Chart 6, February
2000 Gold Comex.
Figure 1: The 2/20 EMA set-up. Source: Technical Analysis of Stocks and
Commodities, December 1996 Issue.
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Chart 4: February Comex Gold. Notice the 2/20 EMA Breakouts (or “Daylightâ€
Breakouts) requires the market to trade above the two-bar high of the set-up for
longs and below the two-bar low for shorts. If the market fails to pass these
points then there is no trade.
Like most trend-following systems, Daylight Breakouts are prone to large
drawdowns (losses to equity) when traded on a purely mechanical basis as markets
only trend about 30% of the time. However, when used on a discretionary basis,
combined with money management and/or additional technical indicators (i.e. a
strong underlying trend) it can be a useful tool. Also, you might consider
varying the lengths (and types) of moving averages used depending on your
trading style. For instance, short-term traders may consider using a 10-period
moving average whereas longer term traders may consider a 50-period moving
average or longer.
Conclusion and Series Summary
In the first part of the series we defined the different types of moving
averages. These included the simple, weighted and exponential moving averages.
These different types of averages essentially behaved the same except in strong
trends and breakouts when the weighted and exponential moving averages tended to
“catch up†faster to current prices. In Part II, we looked at the
characteristics of moving averages such as reversion-to-the-mean and the
drop-off effect. We also looked at general uses which included
support/resistance or reference points and using the slope of the moving average
to measure trend. Finally, we showed more specific set-ups which seek to
capitalize on these features.
So which moving average or set-up is best? It all boils down to personal
preference and trading style. I encourage you to study the different types of
moving averages and the above set-ups. Modify them to your liking or create your
own methods.
References and Additional Reading
Technical Analysis From A to Z by Steven Achelis. I keep this book on my desk
for quick reference. Mr. Achelis covers most technical indicators including
their calculation and general use in a clear and concise manner.
For those looking to jump ahead, I will likely reference moving average
strategies in upcoming articles from some of the following books and/or
articles:
The 2/20 EMA Breakout System, by David Landry, December 1996 issue of
Technical Analysis of Stocks and Commodities.
The TradingMarkets.com Guide to Conquering the Markets,
Edited by Mark Etzkorn. The Running Cup and Handle, Chapter 6, pages 74 through
76.
Hit and Run Trading by Jeff Cooper. Expansion
Pivots, Chapter 8, pages 59 through 67.
Street Smarts by Laurence Connors and Linda
Raschke.
The Holy Grail, Chapter 10, pages 79 through 86