Selling at a moving avarage

Robert Rhea, a prominent market technician during the first half of the twentieth century, described the three stages of a bull market. During the first stage, prices recover from the oversold excesses of the preceding bear market—they rise from deeply undervalued levels back to value. During the second stage, rising prices reflect improving fundamentals. Finally, during the third and final stage, prices rally on enthusiasm, optimism, and greed—people buy “because prices have always gone up.” Rhea, who had done a great deal to popularize the Dow Theory, was writing about bull markets that lasted several years. I found that I could apply his concept to shorter timeframes.

We have already discussed how moving averages reflect a longer-term consensus of value. When prices crash below a moving average and drag it down, a bear move is in progress. When prices stop declining and the moving average flattens out we need to become alert to the possibility that the bear may be dead.

The markets run on a two-party system. When the bear party loses power, we can anticipate that the next election will go to the bulls. The first target for a bullish move would be a rally back to value, up to the moving average.

This approach to buying below value and setting the profit target in the value zone works especially well with the weekly charts. The Triple Screen trading system (see “My Toolbox” on pages 15–17) calls for making strategic decisions on the weekly charts and implementing them on the dailies, where you can make tactical choices on buying and selling.

I recently received an e-mail from a trader friend about a stock he has been trading. Kerry pointed out that the stock had recently broken below its multiyear low and had stabilized. Whenever I look at a stock I haven’t seen in a while, I pull up its weekly chart (Figure 4.1) and compress it so that the entire history fits into a single screen. I want to see at a glance whether the stock is cheap or expensive, relative to its own history. EXTR, with a high above $120 and a low near $3, was trading below $3.50, giving an absolutely clear answer to this question.

Next, I open up the stock’s weekly chart and review its history over the last two or three years (see Figure 4.2). This format allows me to identify long-term price and indicator patterns. Here you can see that the stock’s price has recently broken below long-term support at $4.05. The decline had stalled and the trend had changed from down to sideways. Both MACD-Histogram and Force Index are trending higher—a bullish sign. I decided that a rally was likely to occur and carry prices into the value zone on the weekly chart. That zone was between $3.67 and $3.96, between the two moving averages.

At the right edge of the daily chart (see Figure 4.3), EXTR shows a false downside breakout—one of the most bullish signals in technical analysis. It is confirmed by a bullish divergence of MACD Lines. In addition, the bullish divergence of Force Index is sending an important message—the attempted downside break had no power.

Figure 4.1 EXTR, compressed weekly

Figure 4.2 EXTR, weekly chart

Decision—go long EXTR, with a stop at 3.31 and a target of 3.81, above the upper channel line. The distance from the latest closing price to the target was 37 cents, down to the stop 13 cents. The reward-to-risk ratio was nearly 3:1—not the greatest ratio but certainly a very acceptable one.

Figure 4.3 EXTR, daily chart, entry

It was a nice entry on a quiet day—buying in the lower half of the daily bar, for a 56% entry grade. The day after I bought EXTR it weakened, and the following day it touched a new low. It must have triggered some stops, punishing those who like to place their stops immediately below the latest low. It is important to make an allowance for the normal noise of the markets and place your stop a little farther away, in an area where you do not expect the prices to go.

The following week EXTR exploded to the upside, almost reaching its upper channel in a single day. It closed near the high, but the following day it had a narrow range and could not rise any higher. I saw this is a sign of resistance and sold at 3.63 (see Figure 4.4).

Figure 4.4 EXTR, daily chart, exit

I chose not to hold out for more than the market seemed willing to give. I treat a selling target as a working estimate. If the market appears very strong, I will try to ride the price move beyond the target. If it appears weak, I will get out earlier.

This was a very nice exit, selling near the high of the day, for a 70% exit grade. Even more rewarding was the trade grade. Taking 18 cents out of a 43-cent channel produced a 42% trade grade—an A+ trade. I bought below value and sold near the overvalued level.

One of the essential values of keeping a Trading Diary is that it encourages you to return to every closed-out trade a month or two later (see Figure 4.5). It makes you re-evaluate your performance with the benefit of hindsight. If you keep learning from your experiences, you will become a better trader tomorrow than you are today!

In retrospect, I could have held much longer—but at the time of the exit there was no clear way of knowing that those rallies would come. There are two sure-fire ways to nail every bottom and top. One is to paper-trade using old charts; the other is to lie about your performance. As for the real traders, risking real money, fast dimes are better than slow dollars.

You have to develop a style of trading that feels comfortable and follow it without regrets. Regret is a corrosive force in trading. If you kick yourself for leaving some money on the table today, you will reach out too far tomorrow—and fail.

Figure 4.5 EXTR, daily chart, follow-up

And now let us review another trade.

One of the advantages of the futures markets is that there are so few of them. You can easily review a couple dozen key futures markets as part of your weekend homework. This is how I became aware of the following pattern in the gold market.

At the right edge of the daily chart (Figure 4.6), gold has broken below the support line but closed above it. I learned from David Weis, a frequent guest instructor in our Trading Camps, that a false downside breakout is one of the most bullish signals in technical analysis. The Impulse system on both the weekly chart (not shown) and the daily chart has turned blue, saying that the worst of the downtrend was over, permitting buying.

Notice a severe downspike of Force Index several days prior to the right edge. Such downspikes identify the areas of panic and a washout of weak longs, clearing the air for an advance. A bullish divergence of both MACD Lines and MACD-Histogram between September and October bottoms delivered a powerful buy signal. I bought December 2006 gold on 10/10/2006 at $577.80, with the target near the weekly value zone, above $630 and a stop just below the recent lows.

Figure 4.6 Gold, daily chart

The entry day’s high was 580.80, low 573, making my entry rating 38%—just about a passing grade. My target: a move across the EMAs, towards the upper channel line.

I sold gold three days later, on Friday 10/13 (see Figure 4.7). On the technical side, I did not like the fact that it had a very narrow range on the day it hit its slower moving average on the daily chart. The value zone serves as natural resistance for both upmoves and downmoves. The narrow range showed a lack of progress in an area where resistance could be expected. On the psychological side, I had an incentiveto sell that had nothing to do with the market.

Figure 4.7 Gold, daily chart, exit

Europe the following week and wanted to reduce my market positions to a minimum. I did not want to hold anything that might require time, attention, and babysitting. I guess you could say I was looking for a reason to get out.

My exit grade was 52%, meaning that I sold just above the midpoint for the day. My trade grade was a B., as I took $13.20 out of a $69 channel. Quite a decent grade, but it certainly left room for improvement.

Now, without a Diary, one would close out this trade and move on. The Diary allows us to look back—how good was this trade in retrospect? Let us revisit gold two months later (see Figure 4.8).

When we look back with the benefit of hindsight, we must be careful not to be swept off our feet by the powerful trends that are clearlyvisible only in retrospect. Four days after my exit, gold reached a top and collapsed right back to my entry level. It made two more very tradeable swings from the value zone between the EMAs to the overvalued zone near the upper channel line on the daily charts.

Figure 4.8 Gold, daily chart, follow-up

I had bought below value and sold above it—it was a very reasonable sale, considering the fact that gold was just coming out of its bear market and one had to be very cautious betting on the bulls. When in doubt, get out!

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