Post by TradingForGod on Aug 15, 2004 20:28:34 GMT -5
Hi Everyone!
Today we’re going to talk about the most basic question to ask before you begin trading…is the market trending? I know that seems almost ridiculously simple, but the answer to this question radically affects how you should trade a given instrument. If the market is trending, you should only trade in the direction of the trend unless you are taking profits (duh!). If the market is NOT trending, then it’s pretty likely that prices will revert to the mean of recent price action and you should trade COUNTER to the short term movements at the edges of the recent price action unless one of the following is true:
a) other technical indicators strongly suggest a break-out is imminent
b) you have specific, non-technical, knowledge that support an imminent break-out
I know that most of you are primarily stock traders, and I suspect that you trade from the long side most of the time. My background is in commodities trading where it’s as easy to go short as it is to go long. As a result, I have developed a “neutral bias” with respect to market price action. It has been my experience, however, that equity traders generally have a “bullish bias” since that is the way that they are going to make money, from the long side. This tendency was only exacerbated in the 80s and 90s when the equity market was uni-directionally higher. Most stock traders, even seasoned professionals, trading in early 2000 had never lived through a real bear market. That’s why most pundits on CNBC were saying “buy value” as the Nasdaq fell 78% from the highs. Of course, there are the aggressive shorters in the equity markets too. They look for stocks they feel are overvalued and then sell short. You see many of those folks on message boards “bashing” a particular stock they have shorted. There are few real “neutral” players out there. That has always fascinated me, since in commodities trending markets are the exception rather than the rule. I saw an article a long time ago that said commodity markets are technically trending only 20%-25% of the time. Stocks, especially over the last 25 years, trend much more often. However, if you go back to the 1970s the market was basically flat for a decade. If you were looking to “buy and hold” back then you had better have been doing it for the dividend!
We want to use technical analysis to filter out any biases we have about the market so that we can objectively evaluate the current market conditions for the instrument that we are wanting to trade, whether that’s an individual stock, a stock index futures, crude oil, or pork bellies. So how do we do that as it relates to the question of trend? There are several ways to chose from but I use two: moving averages (MAs), and the average directional index (ADX).
Moving averages are perhaps the most widely known technical tool. I think they are the oldest math-based indicators. People calculated and graphed them by hand long before computers made it easy. The calculation is very simple. The closes of the last “n” periods are added together and then divided by the number of periods. As each new period occurs, the first period in the series is dropped off so that only the n most recent periods are considered. There are a lot of different ways to use moving averages. Some people use only one and consider the market trending when the MA is sloped positively or negatively by a certain amount. Some people use two MAs of different periods and buy or sell when one MA crosses the other. The benefit of these types of systems is that they give signals pretty quickly, so you can get into a trade fairly early. The downside is that they give quite a few “false” signals resulting in a high percentage of losing trades, especially in choppy markets. I use a three MA system to help quantify the strength of a trend. By using three MAs I can get PARTIALLY into a trade when the shortest term MA indicates a trend MIGHT be forming, but it helps me wait to build a position until the longer term MAs suggest that’s the right thing to do. Plus, once the trend is going, I can use the shorter term MAs as trailing stops to partially exit a position if the market begins to reverse. More on that as time goes on.
There are probably as many different MA systems as there are traders. A lot of work has been done back-testing data to try to come up with the “optimum” periods to use for the averaging. I have tried to do that myself. What I have found is that the “best” settings change over time, so optimizing a system so that it works well over all time frames is really hard. As a result, I am still using the basic system I have used for over 10 years. I use the 7, 20, and 40 periods for my fast, medium, and slow MAs. Why those particular settings? Well, believe it or not I use them because 7 is the number of completion in the Bible, there are 20 trading days in a lunar cycle, and the flood and Jesus’ time in the desert lasted 40 days. That’s kind of weird, I know. But heh, I’m a Christian. What can I say? Plus, it seems to work pretty well. Whatever MA system you use to evaluate the market, consistent application is the key.
As to how to interpret the data, if all the MAs are very close to one another with small slopes in different directions, the market is clearly not trending. If the 7-day MA is above the 20-day MA, but below the 40-day MA, the market MIGHT be starting an uptrend, but it is not certain so trade small. If the 7-day MA is above the 20-day MA which is above the 40-day MA the market is probably trending.
The other main way I evaluate trend is the ADX. This indicator, developed by Welles Wilder, measures the STRENGTH of a trend, not its direction. You have to use other means like MAs or visual observation for that. The math behind the indicator is a little complex, so I’m not going to explain it here. It’s not really necessary anyway. You don’t have to know how a carburetor works to drive a car. For our purposes, we’ll just talk about the basic interpretation rules. If the ADX is below 20, especially if the line has a negative slope, the market is considered non-trending. If the ADX is between 20 and 40 with a rising slope the market is trending and the trend is strengthening. If the slope begins to turn lower, especially if the ADX is above 40, the trend is in danger of failing. Beware of a correction at that point.
So let’s look at our friend the MSFT chart to see how to apply the criteria we discussed above. From April through mid-May, MSFT was correcting from the big sell off earlier in the year. Notice how the 40-day MA (blue line) acted as resistance for several weeks in April as the ADX was falling rapidly from high numbers (downtrend eroding). The big gap higher in late April was not sustained because it just completed the correction higher off the lows. The market consolidated in a narrow range through May and early June as the ADX continued below 20 (non-trending). In early June prices began to rise, and MA structure and ADX quickly moved into bullish configuration. Notice how the 7-day MA (orange line) acted as support all the way up until the first part of July. On that dip, the 40-day MA held as support, but note how the ADX was declining from high levels. This indicated that the uptrend was weakening. The big gap higher in late July occurred in the context of this weakening trend and resulted in a “two-day island reversal formation”. Early this month, MSFT consolidated around the MAs that were all clustered together. On August 4th it closed slightly below the 40-day MA, doing so for the first time in over two months. The very next day it fell sharply. The 7-day MA now seems to be acting as resistance and the 20-day MA just crossed below the 40-day MA putting the MAs into the most bearish configuration. The ADX is still “non-trending” however, with a reading less than 20. If that indicator begins to rise, I’d look for MSFT’s weakness to accelerate. That’s how I use these two indicators in tandem.
So that’s the basics of determining a trending market with a little bit of strategy for trading it. Next time we’ll talk about how to trade non-trending market using volatility bands. May all your trades be winners!
Blessings,
TFG
Today we’re going to talk about the most basic question to ask before you begin trading…is the market trending? I know that seems almost ridiculously simple, but the answer to this question radically affects how you should trade a given instrument. If the market is trending, you should only trade in the direction of the trend unless you are taking profits (duh!). If the market is NOT trending, then it’s pretty likely that prices will revert to the mean of recent price action and you should trade COUNTER to the short term movements at the edges of the recent price action unless one of the following is true:
a) other technical indicators strongly suggest a break-out is imminent
b) you have specific, non-technical, knowledge that support an imminent break-out
I know that most of you are primarily stock traders, and I suspect that you trade from the long side most of the time. My background is in commodities trading where it’s as easy to go short as it is to go long. As a result, I have developed a “neutral bias” with respect to market price action. It has been my experience, however, that equity traders generally have a “bullish bias” since that is the way that they are going to make money, from the long side. This tendency was only exacerbated in the 80s and 90s when the equity market was uni-directionally higher. Most stock traders, even seasoned professionals, trading in early 2000 had never lived through a real bear market. That’s why most pundits on CNBC were saying “buy value” as the Nasdaq fell 78% from the highs. Of course, there are the aggressive shorters in the equity markets too. They look for stocks they feel are overvalued and then sell short. You see many of those folks on message boards “bashing” a particular stock they have shorted. There are few real “neutral” players out there. That has always fascinated me, since in commodities trending markets are the exception rather than the rule. I saw an article a long time ago that said commodity markets are technically trending only 20%-25% of the time. Stocks, especially over the last 25 years, trend much more often. However, if you go back to the 1970s the market was basically flat for a decade. If you were looking to “buy and hold” back then you had better have been doing it for the dividend!
We want to use technical analysis to filter out any biases we have about the market so that we can objectively evaluate the current market conditions for the instrument that we are wanting to trade, whether that’s an individual stock, a stock index futures, crude oil, or pork bellies. So how do we do that as it relates to the question of trend? There are several ways to chose from but I use two: moving averages (MAs), and the average directional index (ADX).
Moving averages are perhaps the most widely known technical tool. I think they are the oldest math-based indicators. People calculated and graphed them by hand long before computers made it easy. The calculation is very simple. The closes of the last “n” periods are added together and then divided by the number of periods. As each new period occurs, the first period in the series is dropped off so that only the n most recent periods are considered. There are a lot of different ways to use moving averages. Some people use only one and consider the market trending when the MA is sloped positively or negatively by a certain amount. Some people use two MAs of different periods and buy or sell when one MA crosses the other. The benefit of these types of systems is that they give signals pretty quickly, so you can get into a trade fairly early. The downside is that they give quite a few “false” signals resulting in a high percentage of losing trades, especially in choppy markets. I use a three MA system to help quantify the strength of a trend. By using three MAs I can get PARTIALLY into a trade when the shortest term MA indicates a trend MIGHT be forming, but it helps me wait to build a position until the longer term MAs suggest that’s the right thing to do. Plus, once the trend is going, I can use the shorter term MAs as trailing stops to partially exit a position if the market begins to reverse. More on that as time goes on.
There are probably as many different MA systems as there are traders. A lot of work has been done back-testing data to try to come up with the “optimum” periods to use for the averaging. I have tried to do that myself. What I have found is that the “best” settings change over time, so optimizing a system so that it works well over all time frames is really hard. As a result, I am still using the basic system I have used for over 10 years. I use the 7, 20, and 40 periods for my fast, medium, and slow MAs. Why those particular settings? Well, believe it or not I use them because 7 is the number of completion in the Bible, there are 20 trading days in a lunar cycle, and the flood and Jesus’ time in the desert lasted 40 days. That’s kind of weird, I know. But heh, I’m a Christian. What can I say? Plus, it seems to work pretty well. Whatever MA system you use to evaluate the market, consistent application is the key.
As to how to interpret the data, if all the MAs are very close to one another with small slopes in different directions, the market is clearly not trending. If the 7-day MA is above the 20-day MA, but below the 40-day MA, the market MIGHT be starting an uptrend, but it is not certain so trade small. If the 7-day MA is above the 20-day MA which is above the 40-day MA the market is probably trending.
The other main way I evaluate trend is the ADX. This indicator, developed by Welles Wilder, measures the STRENGTH of a trend, not its direction. You have to use other means like MAs or visual observation for that. The math behind the indicator is a little complex, so I’m not going to explain it here. It’s not really necessary anyway. You don’t have to know how a carburetor works to drive a car. For our purposes, we’ll just talk about the basic interpretation rules. If the ADX is below 20, especially if the line has a negative slope, the market is considered non-trending. If the ADX is between 20 and 40 with a rising slope the market is trending and the trend is strengthening. If the slope begins to turn lower, especially if the ADX is above 40, the trend is in danger of failing. Beware of a correction at that point.
So let’s look at our friend the MSFT chart to see how to apply the criteria we discussed above. From April through mid-May, MSFT was correcting from the big sell off earlier in the year. Notice how the 40-day MA (blue line) acted as resistance for several weeks in April as the ADX was falling rapidly from high numbers (downtrend eroding). The big gap higher in late April was not sustained because it just completed the correction higher off the lows. The market consolidated in a narrow range through May and early June as the ADX continued below 20 (non-trending). In early June prices began to rise, and MA structure and ADX quickly moved into bullish configuration. Notice how the 7-day MA (orange line) acted as support all the way up until the first part of July. On that dip, the 40-day MA held as support, but note how the ADX was declining from high levels. This indicated that the uptrend was weakening. The big gap higher in late July occurred in the context of this weakening trend and resulted in a “two-day island reversal formation”. Early this month, MSFT consolidated around the MAs that were all clustered together. On August 4th it closed slightly below the 40-day MA, doing so for the first time in over two months. The very next day it fell sharply. The 7-day MA now seems to be acting as resistance and the 20-day MA just crossed below the 40-day MA putting the MAs into the most bearish configuration. The ADX is still “non-trending” however, with a reading less than 20. If that indicator begins to rise, I’d look for MSFT’s weakness to accelerate. That’s how I use these two indicators in tandem.
So that’s the basics of determining a trending market with a little bit of strategy for trading it. Next time we’ll talk about how to trade non-trending market using volatility bands. May all your trades be winners!
Blessings,
TFG
