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Trader's Corner

Moving Averages; Final Article (3)

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I've been writing about the use of moving averages in the past two weeks (Wed, 3/8 and 3/15). I'll finish today. The first two articles may be seen in your Option Investor Daily e-mails for those dates, or by going to the OI.com website and viewing the Wednesday 3/8 article by clicking here.

... and the second article (Wednesday, 3/15) by clicking here.

PLEASE SEND ANY COMMENTS OR INDICATE HOW YOU'VE MADE EFFECTIVE OR GOOD USE OF MOVING AVERAGES IN YOUR TRADING. Send e-mails for use in a future Trader's Corner article to Click here to email Leigh Stevens Support [at] OptionInvestor.com with 'Leigh Stevens' in the Subject line.

I've discussed previously 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; assuming you used a two moving average 'crossover' systems to make buy and sell decisions.

Good results in upside moving average crossovers in suggesting upside momentum was seen by using two Simple Moving Averages (SMA), resulted in a best pair of 6 and 21 for the S&P 100 (OEX) and 7 and 25 for the Nasdaq 100 (NDX) on a daily chart basis.

A more 'sensitive' moving average crossover that is quicker to react was also seen in use of a weighted moving average (WMA) for the shorter moving average and an SMA for the longer. An update of those daily charts follows:

Use of this moving average crossover set led to the resumption of an upside moving average crossover (a buy 'signal') by mid-February, that was only briefly reversed from 3/9 to 3/13. Use of an unweighted simple moving average for the shorter moving average length (6) also led to a brief DOWNside crossover. On balance, this moving average crossover indicator is showing good upside momentum in this Index.

The rally that we've been seeing in the NYSE and S&P listed stocks has not been as strong in the tech-heavy Nasdaq and upside momentum in the Nasdaq 100 (NDX), as suggested by the 7 and 25-day moving averages has faltered some already; at least the shorter weighted moving average (with the 'weighted' average reacting more quickly to the most recent closes), has turned down.

This action is coupled with a failure for an upside penetration of the prior highs around 1700 and for a sustained move above the down trendline on the NDX daily chart below:

If NDX is unable to make much further upside traction, and the shorter moving average crosses BELOW the longer, it will remind us of a significant biggest 'problem' in the use of moving averages in making major trading decisions; or, simply their use in 'defining' the trend, which is the tendency to get 'whipsawed' when an Index or a stock doesn't maintain a trend.

It's time to turn to one of the best uses of moving averages which is simply to provide clues to support and resistance. This use also includes the use of moving average envelopes which can provide some clues as to the possible upper and lower support and resistance areas. More on that shortly... FIRST ...

The S&P 100 (OEX) has been seeing resistance at the trendline shown, connecting the prior price peaks of the past few months. Today it rebounded back to this area and may now get through it. It will be a significant test of the staying power of this rally since OEX is also 'overbought' on a short to intermediate-term basis.

Some encouragement for a continued bullish trading stance is provided by my sentiment indicator, which is suggesting that traders are not going overboard in their activities and in a bullish view of the market. Pivotal near support is at 588, with more major support suggested at the trendline currently intersecting at 582. Key near-resistance remains 595.

The Nasdaq 100 (NDX), has NOT managed to break out above the very important 1700 level, but hasn't broken any significant technical support yet either; it still is finding support on a closing basis either the previously broken up trendline or the pivotal 21-day moving average, which was the case today. NDX is at an important juncture too. To maintain bullish potential in terms of the technical/chart pattern picture, NDX needs to stay above 1663-1668 and eventually manage to achieve a couple of consecutive closes above 1700.

You see examples fairly frequently in stocks, and often in the stock indices, where the most watched 200-day simple moving average acts as a support or resistance area. Often I use the e 50 or 55-day moving average along with the 200-day. And, as long as the 50-day is trading above the 200-day, or vice versa, the direction (shorter above/below the longer average) of the dominant trend is in that direction.

With the S&P 500 chart, when the major trend is predominately up, you may see brief dips below the 200-day SMA but these periods are not months long; more often 1-2 weeks.

If you want to reassure yourself as to the DOMINANT trend, look to see if the 50/55-day moving average continues to trend above the 200-day, which is the case below and true since the 11/9 upside crossover during the period shown in the yellow circle in the SPX chart below:

For the option trader, there are occasionally very useful periods to our bottom line where you can buy Index calls on just about every dip to the 200-day moving average, as is the case with the period shown in the S&P 500 (SPX) Index.

When there finally is a break below the 200-day SMA in the period shown below (September), and a subsequent rebound to the Average that is met with continued selling pressure, it was time to buy puts in the S&P.

There are other periods over many months in a dominant downtrend that were prime time windows to buy puts when an Index even got close to its 200-day average, such as in the period shown for SPX below.

Downside momentum was again 'confirmed' so to speak when the rallies failed to reach the 200-day SMA and then crossed back below the 50-day average (the lighter magenta line). Decisions are not made on the basis of the moving average alone, but the rally failures shy of the average are telling when coupled with indications provided by other indicators (e.g., an overbought RSI) and especially a break of an up trendline.

In individual stocks the usefulness at times of the 200-day moving average in defining potential support or resistance can be even more pronounced, as institutional money mangers often base some of their trading decisions on the price moves above or below the 200-day SMA. Examples from my (Essential Technical Analysis) book are seen below, both being charts of Home Depot (HD):

As I've been saying, the usefulness of other technical tools and patterns to determine the trend and to make trading decisions is compounded when coupled with a study of key moving averages:

I will make this a separate article and separate discussion next time in my Wednesday Trader's Corner.

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, 3/18) Index Trader can be seen online by clicking here.

** Good Trading Success! **

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