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Correction

I need to start this article with a correction from last week’s “Trading the Trend” article; specifically in regards to the commentary on the double crossover signal. The article states:

Although the chart itself looks a touch ugly, the detail we want to provide is that of the magenta line crossing up above the pick line. This is the bullish crossover we defined and is the trade signal.

However, I incorrectly identified the 20-day light blue line as magenta and the 50-day magenta line as pick [sic]. Hmmm … way off, I apologize for any confusion.

We’re looking for the shorter-term simple moving average that follows price more closely (the 20-day average which is the light blue line in the chart) to cross up above the longer-term simple moving average (the 50-day average which is the magenta line). This type of crossover, which is shown on the chart, is a bullish signal.

Figure 1: Chart from “Trading the Trend”

A moving average crossover method works best when relatively long trends are in place since the indicators themselves lag price. “Relatively long” refers to successive bars on a chart—this could mean hours on an intraday chart or months on a weekly chart—it depends upon your specific time frame.

Indicator “Speed”

I’ve referred to the 20-day SMA as the shorter line and the 50-day SMA as the longer line. The relationship between these two indicators can also be referred to as “faster” and “slower." The 20-day SMA is more responsive to price changes because the line itself includes recent data points with more weight. A 20-day SMA is constructed using 20 daily closes (each data point has a 1/20^th weight) while the 50-day SMA is constructed using 50 daily closes (each data point has a 1/50^th weight). Additionally, the 20-day SMA does not contain the 30 oldest closes.

This relative relationship based upon the number of periods selected holds for other indicators used in technical analysis as well. “Relative” is stressed again. The 50-day SMA is the slow SMA in this example while it would be considered the fast SMA when charted with a 200-day SMA.

Figure 2: General Electric Daily Chart with 20-Day and 50-Day Simple Moving Averages

Relate this to trading and signals. What happens when you trade “fast”? You’re likely in and out of trades more quickly and prone to market whipsaws. These are signals that remove you from a trade shortly after you’ve entered it due to a false move. On the other hand, when you consider trading slowly you probably have a long term swing or investing mindset. Why do these semantics matter in trading? It’s a way to help you intuitively understand the nature of all indicators. When you feel your system is providing too many signals, perhaps it’s time to simply slow things down.

Trade Signals

The fastest data on our chart is price itself—there is zero lag. Although moving averages lag price, they can serve to slow down our trading by filtering out some signals or false moves. As a result of the lag we also can remain in a position longer.

It is possible to remain in a position for too long, though. What if we wanted to use a slower signal for trade entry and a faster signal for trade exit? There are a couple of different ways to accomplish this using the two indicators we have applied.

Let’s look at the chart from September 2003 to late January 2004. We first see price peak, then the 20-day SMA and finally the 50-day SMA. In late November the price trend changes and crosses up above the 20-day SMA (Alert #1). Around the same time the 20-day SMA turns upward (Alert #2), price crosses up above the 50-day SMA (Alert #3). Next, the 20-day SMA crosses up above the 50-day SMA (Alert #4) and finally the 50-day SMA trends upward (Alert #5). We identified 5 different alerts associated with a new trend.

The 4^th alert—when the 20-day SMA crosses up above the 50-day SMA—was used last week as our trade signal. Look what happens with this trade if we use the same method to exit the position. The move is almost completely retraced. What if we used a faster alert such as #1, 2 or 3? Exiting when price crosses below the 20-day SMA makes for a nice trade. In this particular example, price crosses below the 50-day SMA around the same time the 20-day SMA does due to a quick price drop (alerts #2 & 3).

It’s not practical to pick and choose exits for each trend and expect to use those same parameters for the next one. However, you can consider a system that has a trade entry that is slower than the trade exit. Some traders do this using a faster indicator to exit while other may actually change the chart time interval (single bar/day versus two bars/days). Our rules do not have to be so rigid that our trade entry and trade exit signals are the same. However, they do have to exist prior to establishing a position and the trader needs to understand the implications of his or her rules. If you’re exiting faster you may be creating a system that does not allow profits it run.

Homework

Goals of this three-part article series were to define and describe moving average lines, discuss strengths and weaknesses of the line as a technical indicator, identify a trading system using such lines and providing alternate approaches to such a system. We also discussed the importance of effective money management for all of your trades, including those that are system driven. Such management is essential to trading longevity.

We hope this prompts you to explore different approaches to your trading rules for systems that may need some improvement. Understand the implications of any changes you make and focus on creating systems that can be universally applied. Consider something other than the standard 20-period, 50-period and 200-period moving average. Always keep money management an integral part of your system rules.

To read previous installments of Technical Toolbox, please click here.

Clare White
Staff Writer and Options Strategist
Optionetics.com ~ Your Options Education Site

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