MOVING AVERAGES
Those who have followed my work for some time know that I take a “toolbox” approach to analyzing and
trading markets. The more technical and analytical tools I have in my trading toolbox at my disposal, the
better my chances for success in trading. One of my favorite "secondary" trading tools is moving
averages.
In a past educational feature, I explained how I use my two favorite moving averages: the 9- and 18-
period moving averages. In this feature, I will discuss using three moving averages in analyzing and
trading a market. It's called the "triple-moving average" method.
The moving average is one of the most commonly used technical tools. In a simple moving average, the
mathematical median of the underlying price is calculated over an observation period. Prices (usually
closing prices) over this period are added and then divided by the total number of time periods. Every day
of the observation period is given the same weighting in simple moving averages. Some moving averages
give greater weight to more recent prices in the observation period. These are called exponential or
weighted moving averages.
The length of time (the number of bars) calculated in a moving average is very important. Moving
averages with shorter time periods normally fluctuate and are likely to give more trading signals. Slower
moving averages use longer time periods and display a smoother moving average. The slower averages,
however, may be too slow to enable you to establish a long or short position effectively. Moving averages
follow the trend while smoothing the price movement. The simple moving average is most commonly
combined with other simple moving averages to indicate buy and sell signals.
In the triple-moving-average method, "period" lengths typically consist of short, intermediate, and long-
term moving averages. A commonly used system in futures trading is 4-, 9-, and 18period moving
averages. Keep in mind a time "period" may be minutes, days, weeks, or even months. Typically, moving
averages are used in the shorter time periods, and not on the longer-term weekly and monthly bar charts.
The trading signals generated by a triple moving average may be interpreted as follows: The shorter-term
moving average above the longer-term average indicates a bullish market. When the shorter-term moving
average crosses below the longer-term moving average, the market is viewed as bearish and a sell signal
is generated. If the shorter-term moving average remains below the longer-term moving average, the
market is still considered bearish. When the shorter-term average crosses above the longer-term
average, a possible reversal to a bearish market is signaled.
The relation of the three moving averages can help to better and more quickly define the strength of the
trend and provide shorter-term trading clues. For example, if the 4-period moving average crosses above
the 9-period average, but the 9-period is still below the 18-period, that signals a trend change may be on
the horizon, but it's best to wait for the 9-period to cross above the 18period for a better reading of the
trend change.
The trader who uses shorter timeframes to trade markets is better suited to using the triple-moving-
average method--because trading signals are given faster. But keep in mind the shorter the moving
average, the greater the potential for false signals.
Here is an important caveat about using moving averages when trading futures markets: They do not
work well in choppy or non-trending markets. One can develop a severe case of whiplash using moving
averages in choppy, sideways markets. Conversely, in trending markets, moving averages can work very
well.
When looking at a daily bar chart, one can plot different moving averages (provided you have the proper
charting software) and immediately see if they have worked well at providing buy and sell signals during
the past few months of price history on the chart.
As an aside, veteran ag market watchers say the "commodity funds" (the big trading funds that many
times seem to dominate futures market trading) follow the 40-day moving average very closely when they
trade the grains. Thus, if you see a grain market that is getting ready to cross above or below the 40-day
moving average, it just may be that the funds could become more active.
RSI
The ideal technical indicator, according to Andrew Cardwell, Jr., is one that offers capability to identify and
monitor the current trend, highlight overbought and oversold extremes, and give early warnings of a trend
change.
“The Relative Strength Index (RSI) is such an indicator, offering the best of all worlds,” said Cardwell,
president of Cardwell Financial Group, Inc., based in Woodstock, Ga. The RSI “is the cornerstone of my
trading model,” he said.
Cardwell is a featured speaker at this weekend’s 20th annual Telerate Seminars Technical Analysis
Group (TAG 20) conference here.
“In the lectures and workshops I have given, I have shown how the RSI can be used as either a
completely independent trading model or an addition to and enhancement of a trader’s current technical
approach. I use it as a completely independent model to identify trend, support and resistance,
overbought/oversold levels, divergence, trend change, reversal and price targeting.”
Cardwell said most traders who use the RSI focus their attention on trying to identify bullish and bearish
divergences. He said basic price and momentum divergence can and does help to identify extreme
overbought or oversold conditions in market momentum.
“However, most traders fall prey to the concept of divergence and see it as the end or reversal of the
prevailing trend of the market. All would be right in the world if markets were to reverse from simple
divergence. But there are times when sentiment and momentum are so strong that the market continues
to make new highs (or lows), which will keep the RSI at overbought (or oversold) levels for extended
periods of time.
“Momentum and price corrections, when they do materialize, are usually sharp and swift. After these brief
respites the market is then ready to resume its normal upward (downward) trend. With each successive
new high (low) and divergence formed, anxious traders are ready to call for a top (bottom) and reversal of
trend. However, in strongly trending markets, multiple divergences can and do develop, which only lead to
corrections of the overbought (oversold) condition of the market.
“If a trader attempted to take positions based solely on divergences, he or she would need deep pockets
and eventually exhaust his or her trading capital,” said Cardwell.
While Cardwell takes note of divergence, he said that only shows the market is overextended and needs
to correct the overbought or oversold condition. Even though the RSI is considered a momentum
oscillator, he said it has more values as a trend-following indicator.
“One of the guidelines I have established for myself is to identify a range for uptrends as well as
downtrends. As the market trends higher or lower I will adjust the normal range of RSI (70-30) to account
for the shift in market momentum and bullish or bearish sentiment on the part of the traders. The fact that
this adjustment needs to be made in the range of RSI is one of the first indications that the market is
undergoing a trend change.”
The ability of a trader to recognize a trend change quickly, reverse a position and trade in the direction of
that next trend is the skill that traders must develop to be successful, said Cardwell. “By having a position
in tune with the trend, the trader will have the opportunity to participate in the bigger market moves, which
generate larger profits.”
Cardwell has what he calls “Three Keys to Success: have a trading program, patience and discipline.”
