Pinning down short entry points and confirming trends

You can use one or multiple moving averages to determine trends on a chart, and in this section I work with real-world examples of both.

A short trade using a signal moving average and bearish pattern

Figure 15-5 is a chart of Merck & Co, Inc. (MRK) — one of the world's largest pharmaceutical companies. I like this example because you can clearly see how the moving average defines the trend and how that trend is enthusiastically confirmed by a bearish-trending candlestick pattern (or two).

It's hard to argue that the stock is in a downtrend when the first bearish-trending candlestick pattern appears. That pattern is followed quickly by a bearish-thrusting line pattern. All this bearish signaling occurs over the course of just four trading days and with the stock well under the ten-day moving average.

This chart makes a very good case for the use of moving averages over trendlines because when the first candlestick pattern appears, it's very difficult to draw a line that corresponds with the recent price action. But moving averages avoid this problem by relying on mathematically defined levels that don't have to be shaped to fit recent prices, and in this case a ten-day moving average is appropriate.

Figure 15-5:

A chart of MRK with two bearish-trending candlestick patterns and a ten-day moving average that signal a short trade entry.

Figure 15-5:

A chart of MRK with two bearish-trending candlestick patterns and a ten-day moving average that signal a short trade entry.

If one moving average is good, are two moving averages great? That's often the case, because you can compare the two moving averages to glean even more information about the nature of the price action and the prevailing trend.

When using two moving averages on a chart, you can detect a bearish trend when the moving average with fewer days looking back, or the one that uses a fewer number of days in the calculation (the fast one), is below the moving average with more days looking back (the slow one).

Two moving averages and a bearish pattern giving a short signal

You can see a great example of how it's possible to combine two moving averages with bearish-trending candlestick patterns in Figure 15-6, which is a chart of American Express (AXP), a company best known for its credit card business. This chart is dominated by a bearish trend, revealed by a 10-day moving average that stays mostly below the 20-day moving average.

Two different candlestick patterns show up on the chart in Figure 15-6. The first pattern is a straightforward bearish neck lines pattern that pops up while trading is going on well below both moving averages. A signal like that is enough to justify an entry point in most similar situations.

The second pattern is a bearish-thrusting line pattern, and it appears while the downtrend is still in place. Note that part of the first day of the pattern trades over the moving averages, and a few of the days before the pattern show trading over the moving averages as well. But the trend remains bearish, and the 10-day moving average stays below the 20-day moving average. That means the downtrend is still intact, and you want to hang on to your short position for the immediate future.

Figure 15-6:

A chart of AXP where two moving averages and a couple of bearish-trending candlestick patterns reveal an entry point.

Figure 15-6:

A chart of AXP where two moving averages and a couple of bearish-trending candlestick patterns reveal an entry point.

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