A short-term moving average is a simple and effective trend-following tool. It provides a powerful way to smooth out price action in order to determine the short-term trend, areas of support and resistance, and when a trend is reversing. For a short-term trader looking to capture the meat of the move, short-term moving averages offer an ideal way to decide what side of the price action you want to be on.
Many chartists believe that the only proper way to define a trend is by drawing trendlines. While trendlines are useful, they can leave too much open to subjective interpretation, deliberation, and fudging. Day traders need a quick and consistent method to determine if an idea has immediate short-term trend confirmation. Trendlines leave too much room for a trader to rationalize away a losing position. For example, a trendline drawn for a three-month daily chart might look completely different from a trendline drawn for a one-year daily chart. This sort of uncertainty is exactly what you want to avoid.
It is not uncommon for traders to use charts to rationalize a bad position or to distort reality. Without clear-cut trading rules and the discipline to stick to them, traders can look at charts and see only what they want to see. They might have a position that's causing some pain and, rather than cut the loss, use charts to provide them with a glimmer of hope. Sticking to the correct side of the short-term moving average will provide factual evidence of the short-term trend. This will discourage agitated day traders from cherry picking chart patterns to rationalize a loss.
A moving average smooths price action for a select number of periods. Moving averages usually default to the last closing price, but the closing bid price or ask price can also be used. Simple, exponential, and weighted moving averages are three types that can be employed. Exponential is the most widely used today, because it allocates greater weight to the last trading day, responds to changes faster, and factors in older data rather than dropping it.
If the price of a stock or sector has been consistently trading above its 8-period moving average on a daily chart, the short-term uptrend will been broken once the price opens and closes beneath the 8-period moving average. You can use that as a signal to take some profits if you are long, to be flat, or to trade from the short side. If a trader wants to catch a longer-term move and has wider tolerance for loss, you can use a longer-term moving average, such as the 15-day, the 21-day, or the 50-day.
Short-term moving averages can be used as discipline measures for keeping a trader out of trouble. As a simple trading rule, you should only have a position in a stock that is on the same side of the moving average. If a stock is trading above its 8-period moving average, you can trade from the long side but you should not trade it from the short side. If a stock is trading beneath its 8-period moving average, you can trade from the short side but not from the long side. If you stick to this rule, you will prevent yourself from bottom or top fishing because you will be trading on the same side of the short-term trend as defined by the moving average.
A simple and effective trading tactic is to initiate positions only on the side of the 8-period moving average. If the last price is above the 8-period moving average, then the trend is up. If the last price is below the 8-period moving average, then the trend is down.
The 8-period moving average should be used for individual stocks, sectors, and the broader market. For example, if you are considering going long Dell Computer, the ideal scenario would be for DELL, the hardware index (HWI), and the NDX 100 all to be trading above their 8-period moving averages.
The exponential 8-period moving average can be applied across multiple time frames, including the weekly, the daily, and the intra-day. It can be used in conjunction with the opening price signal and the net price to key you in to the broader trend as well as the intra-day movements of the market.
Which short-term time period you are using is not as important as remaining consistent with the time frame. For example, if a 5-day moving average works well for you, then stick to it. Don't switch to an 8-period from a 5-period in the middle of a trade because you want to nurse a losing position. The reason you are using the moving average in the first place is to remain disciplined in spotting and trading with the trend. From a short-term perspective, the 8-period time frame works well. Experiment with various periods. When you find one that you are comfortable with, give yourself time to get used to it.
The weekly 8-period moving average should be the first trend to look at, as it provides the longer-term trend picture and the broader measure of force. If the last price on the weekly time frame is above the 8-period moving average, then the weekly trend is positive. If the last price is below the 8-period moving average, then the weekly trend is negative (see Figure 6-1).
The chart in Figure 6-1 on page 54 shows Adobe Systems breaking above its weekly 8-period moving average on March 5, 1999. After it opens and closes above its 8-period moving average, it trends above it for the next 10 months in a stellar move. Any trader who used the 8-period moving average trend rule would not have traded ADBE from the short side during this entire period.
After looking at the weekly time frame, the next time frame to look at is the daily one. The daily charts provide a tighter measure of a trend than the weekly charts do. If the last price on the daily chart is above the 8-period moving average, then the daily trend is positive. If the last price is below the 8-period moving average, then the daily trend is negative (see Figure 6-2).
The chart in Figure 6-2 on page 55 shows Veritas Software (VRTS) breaking out above resistance and its daily 8-period moving average on September 2. From September 2 on, VRTS closed above its daily 8-period moving average in all but two instances. A trader following the 8-period moving average rule would not have shorted into this uptrend, and quite possibly would have profited nicely by simply trading on the right side of the trend.
The strongest measurement of a trend occurs when both the weekly and the daily trends confirm one another. Weekly trends often dictate daily trends. However, the daily trend is more important to the day trader, because you are concerned with the immediate market action today. If the situation you are interested in trading
To view this image, please refer to the print version of this book
CI CIh i oc
To view this image, please refer to the print version of this book
does not have mutual confirmation of the weekly and the daily trends, then go with the daily trend.
When you have received daily trend confirmation, the next step is to narrow down what the trend action looks like intraday. The intraday trend is positive when the last price is trading above the 8-period moving average, and it is negative when the last price is trading beneath the 8-period moving average. When examining the intraday trend, always begin by looking at the longer time periods. First determine if the last price is trading above the 60-minute, 8-period moving average. If it is, then determine if it is trading above the 15-minute, 8-period moving average. The 5-minute and the 2-minute 8-period moving averages are less reliable as trend indicators because they are subject to interference from false moves. These shorter-term time periods can be useful for taking profits on reversals, because they will lead the longer time periods first.
The most effective way to integrate intraday moving averages with entry is to make sure that the broader measures of the trend are intact. For example, if the last price is above the 8-period moving average on the daily chart, but beneath the 8-period moving average on the 60-minute chart, don't initiate any new longs or initiate any shorts. Use the move beneath the 60-minute, 8-period moving average to take profits if you are long. If the last price is above the 8-period moving average on the daily chart and on the 60-minute chart, but beneath the 8-period moving average on the 15-minute chart, don't initiate any new longs or any shorts. Use the move beneath the 15-minute chart to take profits if you are long.
Staying on the right side of the 8-period moving average is an excellent risk management practice. Depending on your holding tolerance, you can use the daily, the 60-minute, or the 15-minute time frame. This simple method will prevent a lot of traders from fighting the trend or from bottom fishing. It is a protective intraday entry and exit tactic that, when followed, prevents doubling down and allows you to spot short-term price direction.
Part of the advantage of watching the intraday 8-period moving averages is that you can spot when a trend has almost run its course and is in the process of reversing. When prices first break above or beneath the average after an extended move, take profits and adjust yourself for a possible price reversal.
Day traders should use the 8-period exponential daily moving average as the first category for determining if price action confirms their opinions. If the price is above the 8-period moving average, trade from the long side, but not the short side. If the price is below the 8-period moving average, trade from the short side, but not the long side. This simple rule does not dictate that you must have a position simply because the price is above or below the moving average. It does, however, give you an objective measurement for weighing ideas.
Was this article helpful?
We Are Not To Be Held Responsible If Your Online Trading Profits Start To Skyrocket. Always Been Interested In Online Trading? But Super-Confused And Not Sure Where To Even Start? Fret Not! Learning It Is A Cakewalk, Only If You Have The Right Guidance.