Sunday, May 27, 2007

How To Tell When a Market Has Changed Its Trend

One of the things I've learned over the years is to try not to force my trading methods onto the market. For example many people like to use moving averages and we all have our favorite moving average lengths. Some of us like the 200 day while others prefer the 100, 50 or 20 day moving averages. Some traders use averages that are Fibonacci numbers such as 8,13,21,34,55,89 etc... All of these averages have their place in technical analysis but I think it's a mistake to always use the same averages and expect them to work well on every market.

What I like to do is to take into consideration a market's volatility and the size of its pullbacks. Using a 50 day moving average might be too slow to react to trend changes in a particular market while a 20 day moving average might be too fast. So what I do is find a moving average that contained most of the pullbacks in the previous trend and use this length average for determining trend and trend changes.

Above we have a daily chart of the S&P with a 15 day moving average. Notice the uptrend from January going into February. Also notice how this average contained or provided support for the first two pullbacks. When the average was finally broken on February 27th the trend turned down. On March 9th we had a pullback which I shorted just ticks from the high. The high of the pullback was captured perfectly by this moving average. On March 19th the S&P rallied above the average which turned the trend up. Notice how all of the pullbacks were supported by this same moving average. As far as I am concerned, the short term trend of the market is up until this average is broken. There is no reason to try and short this market until the S&P moves below the average and the slope of the average turns down.

The point of this post is to show how I use moving averages to determine the trend. Of course I'll look the 50 day moving average as well as the 200 day, but so far this year the 15 day moving average seems to be a very important average to watch and follow for the S&P 500. I strongly recommend keeping an eye on this average for this particular market.

You can use this same method on a longer term chart too. Above we have a weekly chart of the S&P with a 65 week moving average. The reason why I chose to use a 65 week moving average is because this average provided support for the market in 1999 and early 2000. Once this average was broken in October 2000, the trend turned down. In March 2002 the market had a pullback (rally) which came very close to testing this average before heading back down again. Clearly this moving average would have kept you away from being a buyer during this time period.

In June 2003 this average was broken which turned the trend up. Notice how all of the pullbacks found support at the moving average. As far as I am concerned, the long term trend of this market will remain up until this 65 week moving average is broken and the slope of the average turns lower.

The 65 week moving average is not a popular moving average that many people follow and that really isn't improtant to me. What's important to me is if this market is reacting to this average based on its volatility. If the pullbacks are contained by this particular average, then this will be the average that I will follow closely on future pullbacks.


chiu said...

Kevin, excellant posting on sharing this very logical approach of choosing the day for the MA.

Could you share whether you have any observation on SMA vs EMA in this aspect ?

We will be fortunate to have you continued posting at your convenient time. Thank you.

Kevin said...

I guess you can use both but I prefer to use simple moving averages.


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