The goal of investing is to find low-risk, high reward entries. Granted, managing and exiting positions are extremely important skills as well. However, a good entry makes the process much easier. The first step in this process is to identify the trend of the stock or market you are thinking of buying. I have touched on the use of moving averages as a way of defining trend. However, there are many methods to achieve similar feedback.
I have been influenced by several great traders and teachers, including W.D. Gann, Victor Sperandeo, Linda Raschke, Dave Landry, Kevin Haggerty and Stan Weinstein. Each of these market professionals agrees that PRICE is the ultimate factor that determines if stock is in an uptrend, downtrend, or transition.
Google Inc (GOOG) Daily
The chart of Google shows price only. It is clear based on this chart that GOOG is currently in an uptrend. The stock is moving from the lower left side of the page to the upper right and it is making higher price peaks and higher price valleys. It is best to keep technical analysis simple. I have been telling clients for years that PRICE and VOLUME studies are the foundation to good technical analysis. Before one starts to study indicators, I recommend first becoming an expert on price and volume.
In today’s computerized world, many of the software programs can be programmed to identify price trends assuming one knows how to do it. As described earlier, moving averages work very well for this purpose. I have drawn trendlines on tens of thousands of charts over the years and I still do. However, the proper use of moving averages can save a lot of time in this regard and reduce much of the ambiguity.
Another way of seeing and defining the trend is with the use of swings or waves. W.D. Gann referred to these reversals as swings. In the 1970’s, Art Merrill wrote a book about this concept and referred to the changes in direction as filtered waves. Many software programs call this indicator a Zigzag.
Above, the chart of Apple Inc. shows a 4% filtered wave overlaid onto the price chart. A filtered wave means that all movement which is less than the filter is ignored. In this case, any pullback of less than 4% does not create a wave. Notice during 2009 this stock made higher bottoms based on a 4% filter. Using this filtered wave theory (Art Merrill, Filtered Waves- Basic Theory), one can quickly ascertain the direction as well as the longevity of the trend of a given market.
Here is the same time period as the previous chart. However, this chart of Apple Inc. (AAPL) has our 2 simple moving averages, the 18-day moving average and the 40-day moving average. Notice that in February the 18-day MA crossed over the 40-day MA and remained above for the entire year. This reflects the same positive feedback that we just discussed with a 4% filtered wave. These are two very different approaches to defining a trend, but both are very simple and the resulting signals are virtually identical in this case.
Why an 18 and a 40 MA? Why not a 20 and a 50 MA? Or exponential moving average? What about the 200-day MA? (one of the most widely used MA lines). These are valid questions. Using a 20 and 50 instead of 18 and 40 would work fine. Frankly the difference between an 18 MA and a 20 MA is quite negligible. Put both on a chart at the same time and you will see what I mean. I favor the 18 MA simply because the slope shift is a little quicker than the popular 20 MA. In addition, for this method of using 2 moving averages together like a buddy system, I have found the simple MA lines to be more useful then the Exponential version. Again, it is a personal thing and the use of EMA’s (lines which give more weight to the most recent closes in a sequence rather than weighting them all equally like the simple average) can be employed with success but you will probably need to adjust the length to make the signals a little more comparable.
In my opinion, moving averages should not be used as an exact science. In fact, technical analysis in general, while having various quantitative benefits, is probably best when not used as an exact science either. The question of the 200-day MA is easy to answer. If we display a weekly chart with 18 and 40 MA’s, the 200-day MA is shown in the form of the 40-week MA. I prefer to use multiple time frames in my analysis because it has proven to be very helpful in refining my stock selection and timing process. Having the ability to look at each individual time frame and its own structure, price action and momentum is useful information when trying to find key inflection points. This will become clearer as I give more examples throughout the text. Also, I will show why I use the 40 MA together with the 18 MA in future articles.