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

Analyzing equities using moving averages and volume


During the month of March, price had finally stopped declining and began to move in a tight narrow range in line with the moving averages. Notice how small the bars were during that time and how sideways the action was. The dynamics suggested that price had finally reached equilibrium between buyers and sellers. A trade setup was in the making.

Around this same timeframe, the U.S. stock market had bottomed. Then, another volume spike occurred over a two-day period in April. This time, price was boosted higher. The difference was that price climbed above its moving average and the fast moving average crossed above the slow one. The most important aspect, however, was that within six trading days, price was trading at its four-month high. This is a significant milestone and a reliable buy signal. These three dynamics (price, volume and time), when combined at market bottoms, are an excellent indication of future price direction.

For the entry strategy there are two alternatives. Enter immediately or wait for a pullback to the moving averages. Whichever the choice, the most important aspect of entry is determining a stop loss in case you’re wrong. While there are many tactics that can be employed, a simple one that works well is to place a stop below the last important low. In this case, the April lows make sense due to being somewhat recent and a rather significant milestone.

Now that we are financially engaged in the market, we need to monitor the progress and move our stop each time a new high is made. Keep in mind that the new high is a time reference, not a price reference for the stop itself. When the high is set, the stop will move to below the last important low on the chart. “Stopping higher” (page 31) shows this dynamic in action. As the market makes new highs, the stop is moved to under the last important low point.

The next significant event took place in July where another volume spike produced a significant gap up in price. This is what is referred to as a “long-range day.” When a long-range day occurs with volume spikes, it is another favorite buy signal. This is the point where the market recognizes a major trend change has occurred and everyone wants in. This signal is the hardest to follow but is often the most rewarding. Few will follow this signal because of the sheer price increase that comes with it. One way to play it is to buy on any new high after a successful test of the moving averages.



COMMODITY TIE-IN

Thanks to recent innovations in the exchange-traded fund (ETF) market, investors can participate in many commodity and stock industries as easily as they do individual equities. There are ETFs tied to numerous commodities, such as coal, oil, grains, gas, gold and currencies. Say you are bearish on conditions in Europe and believe the dollar will appreciate against the euro. To execute your plan, you decide to consider a double-short ETF on the euro. A double-short ETF will appreciate as the euro depreciates, but will do so at twice the rate. It also will lose money at twice the rate if the euro fails to move as expected.

“Up with the buck” (left) shows the same setup as with the ISRG example. There is a volume surge, a trend change and a four-month high taken out in three weeks of trading. The fast moving average crosses above the slow. Because currencies are some of the best-trending markets, this setup has a lot of potential.

To confirm, we can also look at a chart of an ETF that tracks the U.S. dollar. This can be seen in the second chart of “Up with the buck.” Look at the volume spikes that developed earlier and at the market bottom. Here, too, we seem to have a trend change in play. What we don’t have is a new three- or four-month high, suggesting that the momentum to the upside is not as strong as we’d like it to be. This doesn’t eliminate the trade completely, however. Each situation will have slight variations and must be taken into consideration.

There will be times when trends fizzle and you will be stopped out. This stresses the importance of market selection. You want to select an instrument that will generate not only a trend move, but momentum, as well. This is why the three- or four-month high and volume qualities are just as important as the moving average component. These clues indicate that there is potential momentum behind the upcoming move.

A trading system doesn’t have to be complex. It just has to be effective.

Bill Downey is an independent investor/trader who has studied technical analysis of gold and silver since the mid-1980s. Contact him at goldtrends@gmail.com or via www.goldtrends.net

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