STEP 1: DETERMINE WHETHER TO TRADE OR INVEST
One method to use moving averages more effectively, but obviously in a more complex manner, is to use moving averages as support and resistance indicators.
So, in this instance, you ignore traditional support and resistance lines and use signals based on specific moving averages. The trick is to combine exponential with simple moving averages to get a Moving Average Trigger.
A brief reminder: common verses exponential moving averages.
Simple moving averages are basic lines based on a number of days taken as an average. These indicate the average price paid for a share over time, but are susceptible to giving traders false signals.
Exponential moving averages have a greater weighting on recent prices as opposed to average prices. The greater emphasis on current prices mean that traders can rely more accurately on signals. As such, traders can use exponential moving average to quickly detect changes in trends.
Note that simple moving averages are a smoother line than exponential moving averages. The combination of simple and exponential moving averages provides a unique look at the
market, providing traders with signals for both short and long-term trades.
It must be stressed that there are no hard and fast rules as to the length of time used for both the simple and exponential moving averages. This depends solely on your trading style and strategies. Whatever timeframe you use, ensure that you test and re-test signals before you adopt these as strategy.
While there are no rules as to timeframes, experience shows that the following are popular among professional traders: Look at the 10 Day SMA and 30 Day EMA to determine if you should be focusing on long positions or short positions.
Here are the rules for timing your trades to the market using moving averages. If the 10 Day SMA is above the 30 Day EMA: Buy long positions only. If the 10 Day SMA is below the 30 Day EMA: Buy short positions only.
This simple technique identifies the underlying trend and helps traders quickly decide whether a position is right for them. Here is an example:
Looking at the chart above, a mere glance can tell you when to trade (buy for the short term) or whether to buy as a long term investment. The above strategy is fine and can be used without further signals being added. However. It is preferable to add an indicator to determine whether the above triggers could be affected by oversold or overbought positions.
As moving averages are trend following indicators, they only provide sound signals in trending markets and not when the share is moving sideways. At this junction, we need to establish whether the trigger has substance, which we do by adding the Williams %R technical indicator.
STEP 2: ESTABLISH SUBSTANCE
The Williams %R indicator is a momentum indicator and measures whether a position is overbought or oversold. The indicator is easy to use and the oscillator fluctuates between a zero level and 100. When the indicator lies between 80% and 100%: share is oversold.
When the indicator lies between 0% to 20%: share is overbought.
The indicator uses the closing price relative to a price range over a predetermined period. The default setting in most charting packages is 14 periods. Many professional traders use a setting of 3, which is far more sensitive. When combined with the sma and ema, the following rules apply:
Trigger indicating an Oversold position: 10 Day SMA > 30 Day EMA and the Williams %R is less than -80..
Trigger indicating an Overbought position: 10 Day SMA < 30 Day EMA and the Williams %R is greater than -20.
Comment: The greater the overbought or oversold position (as indicated by Williams %R), the greater the chance of a market reversal happening.
Rule:
o Go Long: Williams %R is at -90 or below o Go Short: Williams %R is at -10 or above Here is an example:
Comment:
Block A: Indicates that the moving averages highlight a LONG TERM BUY. This is supported by a Williams R% level of below -80%.
o The share moves from level C to Level D
Block B: Indicates that the moving averages highlight a SHORT TERM BUY. This is supported by a Williams R% level of below -20%.
o The share moves from Level F to Level D.
The importance of these triggers is that they are specifically for day traders as the triggers are not predicting future events, but short term trends.
Many professional traders use the above method to identify when to establish long or short positions, and then they use different sets of criteria to determine length of holding, whether to go long or short and when to exit the trade.
Stated differently:
Traders want to know when to buy or sell at the most opportune time. This is really just another of saying that traders want to buy at the lowest point and sell at the highest point. This is seldom achievable as Institutional funds tend to sway markets before you are able to find that top or bottom.
Another point of advice from the professionals:
o Traders tend to be bearish when the market moves strongly and gets near the top of the Sell trigger.
o Speculators tend to be bullish when the price is climbing.
If you set triggers, then use them and not try to add the elements of speculation into the mix. That is always a disaster for traders.
CHAPTER SUMMARY
The chapter was designed for those keen to further their studies of technical analysis. In this case, an ability to understand signals to such an extent that traders can combine various signals to personalise entry or exit triggers.
IN THE NEXT CHAPTER