From the April 01, 2010 issue of Futures Magazine • Subscribe!

Analyzing equities using moving averages and volume

A myriad of technical indicators and methods are available in today’s age of instant market access and powerful trading software. Rather than help, however, the extreme levels of excess information can make trading a difficult undertaking if that information can’t be processed properly.

Popular trading approaches come and go, and in today’s stock market technical analysis currently is growing in popularity. There are many software programs that traders can use for analyzing the markets. Traders with all experience levels are backtesting ideas and methods that they hope will extract profits from the markets. One question all traders should ask, however, is if backtesting and developing a profitable trading system is such an easy route to profits, why doesn’t everyone have one by now?

While the promises of market pundits and trading software vendors may diverge on this matter, the truth is that while backtesting can create an optimum strategy for trading the markets of the past, many times these strategies fail at what really matters: trading the markets of the future.

A system that has been backtested and optimized will only perform as long as the parameters the market depicted during the testing period persevere. That is why some systems will perform well for a while and then collapse. The reason these trading systems break down is that market instruments, from commodities to equities, constantly go through mode changes within their respective trends, as well as shifts in fundamental supply and demand factors. The markets change constantly.

PERSONALITY MATTERS
Because the markets involve human participation, human psychology is a key element to market movements. The effect of mass-market psychology on price is a difficult parameter to analyze for the simple reason that human interpretation of data and facts can and does produce significantly different conclusions among participants. Therefore, determining the future course of price trends is not and will never be an exact science. If it were, economists would be stock traders, and the Greeks would have cornered the olive oil market a long time ago.

The number of trading systems that have been developed over time is as many or more than the markets to trade. Some of these systems have been simple, and some have been enormously complex. Many times, the more complex systems attempt to solve the psychology component. Few, if any, have succeeded. For most traders, it’s better to acknowledge the unpredictable psychology component and devise strategies that trade around it and are not based on it.

We can do that by focusing on simpler systems. At the basic level, only two components are required in a system: an entry rule and an exit plan. No matter how complex or simple a system is, its main function is to determine when to buy and sell. Here, we will review a simple but effective entry and exit system devised for stock selection. It is a basic entry and exit tactic that uses moving averages (trend) and volume (liquidity flow).

FOLLOWING THE FLOW
Another important element to trading system success is market selection. If the stock you choose to trade is not in a defined trend, your chance of success is limited.

One of the quickest ways to find a market instrument that trends well is to look for one that performs strongly based on a moving average. We prefer to use Fibonacci numbers to set our slow and fast moving average levels. Here we use a 34-day SMA for our slower average and a 13-day for our faster moving average. “Steady mover” (right) is an example of just such a stock, in this case ISRG (Intuitive Surgical Inc.). It has an eight-month track record of a downtrend that has not gotten too far ahead of the moving averages. While it is not a guarantee that this specific equity will continue to trend into the future, we know that in its recent past, it trades within the confines of this moving average pair. That give us an edge.

The next indicator of a likely move is a volume spike. While moving averages may point to the right road to take — and the direction to travel — volume is the fuel that propels price changes. A volume surge of 300% to 500% should get your attention. While the first volume spike highlighted on “Steady mover” did not produce a new uptrend, it also did not precede a drastic selloff. Such a development should also get your attention. It’s a clue that price might be nearing a bottom. In this case, over the next three months, price continued in a downtrend, but a slowing rate of descent was observed.

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