Clif Droke
©2002 - 2010 Publishing Concepts

Moving averages and stock market timing

Let’s take some time out to talk technicals. We’ve frequently discussed the usefulness of moving average combinations when it comes to market analysis (support/resistance) and stock trading. Having the right combo or series of moving averages is important. But even more important is having a disciplined approach for entering and exiting a trade based on those moving averages with basic rules for entry and exit.

We employ two basic moving average systems as part of our trading strategy, the first being the 5-day/15-day MA approach for immediate-term buy and sell signals. The second is the 30/60/90-day MA series which is used for established trends (up or down) over an interim time frame. We’ve used both moving average series to good effect over the years and while no system is perfect, this particular system has proven its worth.

We don’t rely exclusively on moving averages to generate buy and sell signals, though. This would be too much reliance on mechanical systems that focus on externals (namely price) to the exclusion of more important variables such as time (cycles) and internals (momentum). If a trader were to abandon all attempts at using cycle analysis and internal momentum analysis and just rely on the moving averages, could he succeed in keeping on the right side of the market most of the time? Perhaps, but there would be too many whipsaws along the way to be considered acceptable and a purely mechanical moving average trading system would probably require a great deal of capital to see him through the rough spots along the way. Combined with the right indicators, a moving average system can be quite profitable over time, assuming you employ a conservative money management and stop-loss discipline to accompany it.

For purposes of this discussion we’ll focus on the 5-day/15-day MA system. The 15-day moving average is the key in this combo; in fact, we can largely ignore the 5-day MA as it’s used primarily to underscore reversals by crossing over or under the 15-day MA but isn’t necessary to use. The 15-day moving average is the dominant immediate-term (1-4 week) trend line in our trading methodology so we’ll take some recent examples of how this can be used in assessing market conditions.

We got our confirmed buy signal based on the 15-day MA trading system on March 12, when the S&P 500 (SPX) closed above the 15-day MA. The following chart shows this breakout above the main immediate-term trend (yellow line). From there the market continued its ascent into April with only one small whipsaw along the way, a 1-day close slightly under the 15-day MA on April 20. After a quick recovery back above the 15-day MA, the SPX continued to climb but at a slower rate of change to its recent closing high of 929 on May 8.

On May 13 the SPX closed again below the 15-day MA to send a sell signal based on the system, tried to recover back above the 15-day MA but failed, then closed above the 15-day MA once again on May 18. In order to qualify as a re-entry signal, price should ideally close at least two consecutive days above the 15-day moving average with the following caveat: the second day in which price is above the 15-day MA the closing price should be above the opening value for that particular day. Otherwise the re-entry signal is invalided. The follow-up to the May 18 session in which the SPX closed above the 15-day MA never proved to be a legitimate buy signal since the price closed under its opening value on May 19 and once again closed under the opening value on May 20.

On May 28 and 29, the SPX once again succeeded in closing two consecutive days above the 15-day moving average. Moreover, on both days the close was above the opening value for the day. This qualified as a technically valid re-entry signal for immediate-term oriented traders.

When using this type of moving average system, in order to produce consistent gains over time a trader must follow the rules of the system in a disciplined fashion. The system is not without is flaws and “whipsaws” are inevitable from time to time. Even greater results can be achieved when such a moving average trading system is combined with a system that tracks internal momentum. Internal momentum provides a strong clue as to whether or not a moving average entry or exit system will likely prove itself productive. In our next installment we’ll discuss the concept of internal momentum in greater depth.

--Clif Droke
clif@clifdroke.com