Moving Averages

By: Joe Duffy

The following is an excerpt from Joe Duffy's Target Zone Trading

Defining Trend

The first idea I would like to cover here is not really a support and resistance technique, but just a blatantly obvious way of not getting in the way of a trending market.  It is so obvious that many traders tend to look right past it.  I think a lot of technical analysis is like this; that the “obvious” techniques often work best when we first discover them.  After a while the technique or system seems to lose its appeal.  Is it the technique, or is it because it becomes familiar, as we do not give it the same scrutiny and observe its rules for use the same way we did when it was new and unfamiliar?  In my view it is likely the latter.

In any case, trend is very important because we want to sell resistance in downtrends, and buy support in an uptrend.  This is a good visual way to determine trend.

I use 3 exponential moving averages.  The shortest moving average should be around 4 to 6 days, the medium one around 9 to 12 days, and the longer one around 20 to 25 days.  I am going to use the 5-10-20 combination for this discussion.

The logic of using these moving averages lengths comes from the fact that somewhere around a 5 and 20 moving average parameter set shows a gross profit (before slippage and commission), in most stocks and commodities using a moving average crossover system.  A moving average crossover system is one where the 5 day crosses a 20 day average on the upside for buy signals, and crosses on the downside for sell signals.

In using the 5-20 moving average combination as a guide to trend, I prefer the long side if the 5 is above the 20 and I prefer the short side if the 5 is below the 20.  Do I ever overlook this rule?  Sometimes, but that is a matter of there being a preponderance or other evidence.  For newer traders observing this rule can help to keep you out of trouble.  As you become more experienced, you might want to ignore this rule occasionally, dependant on what else is setting up, but you cannot do it too often.

Again, this is so simple that many traders overlook it.  But go back and look at your “bonehead” trades over the last few months.  How many could you have eliminated using this simple procedure?

Convergence

The other major use for the moving average combo is to look for convergence.  Convergence occurs when all three averages come together quite closely at a particular price point.  When the 5-10-20 exponential moving average combinations are literally lying on top of each other, a breakout move is likely to start soon.

When that happens the market is often getting ready for a major price break, or trend move.  This convergence is definitely worthy of your attention – as the chances are high that a money making opportunity is on the near term horizon.

Moving Average Kiss

When the 5 period is below the 20 period and the market rallies back, you will often find price resistance where the 5 approaches the 20 period moving average.  When the 5 period is above the 20 period and the market slips back, you will often find the price support as the 5 approaches the 20 period moving average.

This is the phenomena I call the “kiss”.  As when the 5 gets close to the 20 it often just kisses it briefly and then turns around.

Moving Averages II

Moving averages can also be used as price support and resistance levels.  I use 20-50-90 exponential moving averages for this.  Again, these are just one element in a plan to combine different techniques and integrate different time frames to find high probability support and resistance areas.

You can also look for the concept of confluence here.  It will not happen nearly as often as it will with the shorter length averages.  When it does though, the market is usually sending you a very strong signal that a trend is about to start.

First Retrace Failure

This is a phenomenon that I have observed repeatedly in using the moving average combo.  Once a market makes it through all of the 20-50-90 period averages and trades under them for a few bars, the first retracement back up to the moving average cluster will most often be turned back.  This turn back does not always produce a big move, but it sure does very often produce a tradable move.