Option Investor
Trader's Corner

Moving Averages and 'Optimal' Settings (2)

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In my Trader's Corner article of last week I discussed the basic characteristics of the different TYPES (Weighted, Exponential or 'smoothed' and Simple) of moving averages last week, as well as a basic view of the procedure to 'optimize' moving average LENGTHS for most profitable results; that is, assuming you used a two moving average 'crossover' systems to make buy and sell decisions.

For example, testing 5000 days of data for the S&P 100 (OEX) and Nasdaq 100 (NDX) and assuming only a buy the next day after there is an upside crossover (a shorter average crosses ABOVE a slower average on the close) of two Simple Moving Averages (SMA), resulted in a best pair of 6 and 21 for OEX and 7 and 25 for NDX. You can see those charts next and you can go back and see last week's article online by clicking here.

The following OEX daily chart has the two moving averages, 6 and 21 applied to it. Both are Simple Moving Averages. I never use a two moving average 'crossover' as a sole reason to get into calls or puts. However, suppose I liked the signs suggesting that the recent correction had run its course. The Index came to a point where we could draw an up trendline. OEX then rallied back above the 21-day moving average and here the use of the moving average is as an indication of 'resistance'.

We might then wish to use a moving average crossover that has 'tested' well (optimization) on the buy side and wait to buy or perhaps only as a trigger to add to initial OEX call buy. The 6-day SMA crossed above the 21-day SMA only based on yesterday's close, so theoretically the buy indication would have occurred on this morning's (3/15) opening at 589.

We could have anticipated that such a crossover would happen based on the strong move that developed yesterday when OEX opened at 584 and climbed during the day closing over 589, but a more 'subjective' judgment like this might not suit everyone. We could use a 6-day moving average that would give more weight to the most recent close(s) and was more 'objective'.

Using the 'weighted' moving average of my charting application (TradeStation), the upside crossover occurred on the 3/13 close at 584, so the call buy was indicated on the 3/14 OEX Open at 584, which in hindsight improved our entry considerably; not only by the 5 point lower Index value but by the fact that the index options premiums werent as inflated on the opening.

I say 'in hindsight' because that's what it is here. Had we used this set of moving averages as a 'signal' to enter/exit the S&P options over the period since December, there were a number of short-lived crossovers, but on balance the use of the shorter-term WEIGHTED average kept us in more of the move. The last downside crossover was very short-lived, and given the bullish up trendline that was forming, might have been ignored.

Or, in the above example, exit of calls bought down in the 579 area (last upside moving average crossover), might have been done in the 582 area, and retry made at 584. In short, there are many uses of moving averages crossovers short of as a 'mechanical' system, but some stock traders use them successfully just that way. However successful options trading requires a different level of trend sensitivity for the most part.

Let's see where the crossovers of the 7 and 25-day Simple Moving Averages (SMA) are showing us on the Nasdaq 100 (NDX):

Well, as we know the Nasdaq has lagged well behind the S&P and the NDX fell to the low end of its multi-month trading range. The upswing from this recent low is still rather far from achieving a bullish upside crossover of the 7-day Average ABOVE the 25-day SMA.

The NDX held the low end of its trading range and provided the kind of trade entry I am endlessly advocating; e.g., buy on pullbacks to prior well-defined lows and don't wait for upside momentum to develop, rather just assume it may and put a very close-by 'stop' or exit point just under the line of prior support. Still, we could use an upside moving average crossover perhaps as a 'confirming' signal of upside momentum and/or a place where we might add to calls. But that's yet to come on with a moving average CROSSOVER set of two moving averages like this.

Use of a Weighted moving average for the 7-day is closer to a bullish crossover, but it's yet to come also, but is of course nearer to happening as this average, versus the SMA (giving EQUAL weight to the last 25 days' closes), generates more of an upside move based on the strength seen in the last two days.

Since NDX made a triple bottom around 1640, crossed ABOVE 'resistance' implied by the 21-day (Simple) Average and ABOVE the down trendline shown below, it seems that the lagging 'rear-view' mirror analysis provided by moving averages is of limited use as far as an everyday decision tool.

The advantage of the quicker reacting weighting of a weighted moving average is getting out of a position quicker when the trend momentum, up or down, slows. A principle disadvantage, assuming you are mostly relying on the moving average to get you into or out of a position is being 'whipsawed' and having an increased number of losing trades.

In what can be a more effective use of giving STRONGER weight to the most recent close(s), making it a more 'sensitive' average, is as a tool to exit a trend AFTER a big/prolonged move already.

Get back in the stock or Index only when a quicker reacting indicator and trend analysis suggest getting back in the direction of the dominant trend; and possibly then only for SHORTER-term price objectives. OR, get back in when the intermediate chart pattern (e.g., a break of a major trendline) or OTHER intermediate indicators suggest (e.g., a Moving Average Crossover) suggest that the intermediate trend has reversed.

I usually assume that the weighted moving averages are most appropriate for shorter-term TRADING, where the average transaction is completed in 1-day to 1-week. Simple moving averages, especially in the 50-200 length range, are appropriate for an investment-oriented time frame of longer duration, which is many weeks to months, or as long as a major trend continues; especially if you base a broad 'in' or 'out' of the market based on only when the 50-day average is trading ABOVE the 200-day SMA.

The importance of the exponentially smoothed average will principally be of interest to most users of basic technical indicators because the popular Moving Average Convergence-Divergence indicator or MACD ('macdee'), uses the Exponentially Smoothed method of calculating a price average, which I went into in depth in a prior recent Traders Corner article on use of an exponential average in the MACD oscillator indicator

There have been many questions that I received in the past such as from readers of my past (CNBC.com or Option Investor) columns, as to what moving average length is 'better'. The answer is that it depends on your trading or investing horizon.

A 5 to 21 period 'length' will track the very short-term or minor trends. 9 (or 10), 14 and 20 are fairly common moving average lengths also. You will often see the 'default' number in moving average studies as 9.

I prefer a 21-day moving average as a means of tracking the week-to-week trends and a '21' setting on hourly charts. The result of using 21, versus the more common length setting of 20, is virtually indistinguishable.

Use of 21 would be explained by my fondness for using 8, 13 or 21 as a 'fibonacci' number; i.e., the number series 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, etc., where each number is the sum of the prior two numbers. I tend to use 8 as my length for moving averages on weekly and monthly stock and index charts and a 21-day (or hour) moving average on daily charts.

For the intermediate or secondary stock trends, there is little question that the 50-day moving average or 10 weeks (5 trading days in a week: 10 X 5 = 50), is a 'convention' or common length setting that is very common for stocks.

The reason for this particular length, versus some other, is partly convention - however, I also think that it is because 50 is 1/2 of 100 in terms of days, and 1/10 of 100 in terms of weeks 100, its fractions and multiples, is a significant number in our decimal system and in trading. I suspect also that 10 weeks is simply long enough to capture the trends in the market that are of intermediate or secondary duration.

For displaying or capturing the long-term (major) trend, the 200-day moving average wins hands down as the single most widely used Simple Moving Average in the Market in general; the 200-day SMA (sometimes the 150-day SMA) is used or noted daily or weekly by many, if not most, investment-oriented stock market participants. Some chart books and commentators refer to equivalent average in weekly terns; i.e., the 40-week moving average.

If you follow my Index Trader columns you will see endless examples of my use of the 21-day moving average as part of moving average 'envelopes'. You will also see many examples where the 21-day moving average appears to define an area of support OR area of resistance in the major stock INDEXES, which I also discussed above with the NDX chart; also the same can be said of the 50-day and 200-day simple moving averages appearing to provide support or define resistance in the stock indices.

I will get into more of a discussion of the topics of moving averages as support/resistance and the use of moving average ENVELOPES in my next Trader's Corner article next Wednesday.

This Wed. Trader's Corner article also serves as an adjunct to my weekend 'Index Trader' column. In the article you're reading here I can briefly update a technical picture of the market as of midweek, and then use recent chart/indicator patterns to more fully explain their relevance to trading decisions in general.

More on my specific predictions, support and resistance, etc. is found in my weekend Index Trader column, available on the Option Investor.com WEB site (not part of the e-mailed weekend OI Daily). You will normally see a web LINK to the Index Trader at the top of your weekend Option Investor Daily e-mail, but in the rare event that the link goes missing (as happened this past weekend), my Index Trader can still be found on the OptionInvestor.com web site. My most recent (Sat, 3/11) Index Trader can be seen online by clicking here.

Please send any technical and Index-related questions for possible use in my next Trader's Corner article to Click here to email Leigh Stevens Support [at] OptionInvestor.com with 'Leigh Stevens' in the Subject line.

** Good Trading Success! **

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