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Trader's Corner

It's Not Rocket Science

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If you've picked up a trading-related magazine such as STOCKS & COMMODITIES, you know that purveyors of different software programs have developed ever more complicated systems to trigger trades.

It doesn't have to be that hard. It's not rocket science, folks. Pick out a moving average or a trendline and use it as a benchmark.

Annotated Daily Chart of the SPX:

Traders who had entered long SPX-related trades on the first tall green candle that broke out above 1290 in August 2006 were glad to then see the SPX take off again after dropping down to test it a second time. Those traders might have noticed that while 1290 support was being retested, so was the 30-sma. In fact, it was the second time the SPX had bounced off that average since the middle of August.

Light bulb moment. The 30-sma could be used as a benchmark. The long position was performing well as long as the SPX continued bouncing from the 30-sma and bouncing hard enough to keep the 30-sma climbing--this will be an important point later. Traders could even use that as a benchmark for adding to the position, on pullbacks to and bounces from the moving average.

Unfortunately, it would be another couple of months until the SPX was to pull back to the 30-sma, but the 10-sma was functioning as sort of a secondary benchmark, although not nearly as exact. For long-term traders, stops could follow the SPX higher, being placed an account-appropriate distance below that 30-sma. Perhaps traders might require a daily close beneath it or an intraday move a certain distance or percentage level below it.

Other conditions were being fulfilled. Most pullbacks were finding support at previous resistance levels, so that there wasn't much overlapping of highs and lows as the SPX climbed. It was possible to draw a rising trendline and buy pullbacks to the trendline. Perhaps it's possible to eyeball that chart, however, and note that in late November, the SPX would have violated a rising trendline while it still bounced again from the 30-sma. Traders following the trendline with their stops rather than the moving average certainly couldn't have complained if stopped out of their long SPX-related positions up near 1380, however, if they'd been in those positions since 1290.

At the second arrow, however, at the right edge of the chart, something appeared to be changing. The SPX was beginning to trade along the 30-sma rather than bouncing smartly from it. The 30-sma was beginning to flatten. It was no longer climbing. Was it time to get out?

Maybe, maybe not. It was certainly time to begin planning the conditions under which an exit would be made, if stops hadn't already been hit as that 30-sma was tested in early 2007. It was time to realize that the former stop-setting mechanisms, following the moving average higher, weren't going to work and a different stop mechanism would be needed, such as a stop beneath a certain horizontal support level or something similar.

A flattening of a benchmark moving average can signal that the trend is losing steam. Markets can then sometimes move into a period of disorganization in which the moving average loses its benchmark status and prices chop across it. Traders depending on bounces from a moving average to add to positions or drops below it to exit them would be whipsawed out of multiple positions.

Annotated Daily Chart of the SPX:

Traders who followed the SPX higher, placing their stops for their long SPX-related positions at an account appropriate level were stopped out either at Point 2 or Point 3, depending on how tight their stops were. Although there might have been some shoulda-woulda-coulda moments for those who were stopped out at the lower Point 2, even those traders had hefty profits in hand.

After a period of disorganization, the SPX began a new rally period.

Annotated Daily Chart of the SPX:

While it's not rocket science, it's not always as easy as these charts make it appear to determine when a new trend has begun. Prolonged periods of disorganization often follow an established trend, and a trader who isn't careful can get whipsawed. Expecting a period of disorganization after a trend benchmark has been violated is a good practice. Traders tempted to trade before a new trend is firmly established should keep stops tight to avoid incurring large losses in a time when they're more likely to be whipsawed out of trades.

Annotated Daily Chart of the SPX:

The progression tends to be the establishment of a new trend rising out of a period of disorganization, with some moving average or trendline established as a benchmark. Somewhere along the way, the move can grow so exuberant that prices swing far away from that benchmark, often a sign of danger. That can be an ending sign.

So, the cycle starts again. Prices that then come in but don't bounce sharply from or back from the average or trendline might hover long enough to flatten the average. As stated earlier, that's a signal that momentum may be slowing. Traders should prepare exit plans if not using trailing stops.

A flattening of the average often precedes a stronger violation. Once again, a period of disorganization often results before the establishment of a new trend or a resumption of the previous one. Once again, care should be exercised when trying to trade that period of disorganization. Tighter stops are often required. A new trend may appear to have begun, but it may only be soon reversed. Eventually another new trend is established or the old one is resumed, and so it repeats again.

Finding a benchmark and following it can be useful on short-term intraday charts and on weekly charts and everything in between.

Three-minute chart of IBM on 1/7:

The same pattern can be observed on this three-minute chart as was observed on the daily one for the SPX.

Of course it's not always that easy. I didn't pick and choose among charts, but I am looking backward and hindsight is always easier. The SPX's was the first chart I called up for a look at daily patterns, and I just took the last year or two for observation. IBM's was the first chart I looked at for an intraday observation, so it should be obvious that these patterns repeat. However, other periods on IBM's chart demonstrate how traders can get whipsawed trading those periods of disorganization that occur as one trend is ending.

Annotated 3-Minute Chart of IBM:

Which moving average should traders use as benchmarks? Whichever one works. There's no right or wrong, no one-size-fits-all. The rate of ascent or descent of the trend as well as the length of time you intend to stay in the trade help determine the moving average that might be used. I find that a benchmark average often converges with a rising trendline, and they can be used to corroborate each other.

An early trend may show some exuberance, bouncing from a 9-ema or a 10-sma, but those moving averages will not likely serve to define a long-term trend. If you don't believe the trend will be long-lived, you might set stops an account-appropriate distance beneath a moving average of that interval.

If you think the movement might be a long one and you intend a longer-term trade, you might check for a second corroborating moving average that's rising just underneath the one you have been following, perhaps a 20- or 30-sma. Play around with it. Find what works best for you. It's not rocket science.

Trading like this does require some kind of feel for how trends develop and then progress, however. It requires an ability to step aside and not jump in too soon when a period of disorganization develops. It requires an oh-well, another-trade-will-be-along attitude when a pullback or bounce gets too big and you're stopped for a smaller profit and the trend then continues to produce bigger profits, but you're not participating.

If you're already developing a feel for how trends develop and willing to stand aside when a period of disorganization has begun, then you're somewhat wary of participating in markets right now. The SPX has been in a period of disorganization, chopping back and forth, this week finally rising across the flattening 10-sma. We know from previous observations that the fast 10-sma may be violated when the initial stage of the trend has been spent. History tells us that it's too fast an average to serve as a long-term benchmark, however, so if we're in a long-term downtrend, a violation of the 10-sma won't be enough to make its end.

Annotated Daily Chart of the SPX (snapped midday 2/1/08):


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