Con-tango

Moving averages

Moving averages are another good source of supports and resistance, – as we saw in the previous post’s MA bounce method.

I prefer to use EMAs, and I’ve found the following EMAs quite helpful: 5, 13, 20, 50, 150; – most of them are widely followed by traders.

If prices are above all of these EMAs, then the underlying is in a bullish trend; at the opposite extreme, if prices are below all these MA’s the underlying is in a bearish trend.

If we pause to think for a moment, the above is evident, if prices cross above (below) all EMAs there are no EMA resistances (supports) left, – it’s clear sailing from here on… And, this is why trend following methods derive their triggers in reference to MAs.

Of course, clear sailing is always subject to vanquishing the last high (low) if the trend is long (short).

I also use a 20 day Bollinger band, a 2 standard deviation band around a 20 day simple MA. If we accept that the distribution of prices is normal (which isn’t true, – much harsher price extremes may occur, check Nassim Taleb and his black swans; but, behaves that way most of the time), then we know that prices close to the band will tend to regress to its MA. In a way, the bands can also be viewed as supports and resistance; prices are contained within the bands with a 95% probability.

In our GOOG chart, observe how things have changed dramatically for GOOG’s prospects; till December, prices were above all EMAs with shareholders cheering along, today’s prices are under all EMAs, testing February’s important low, with apprehensive shareholders praying for a bounce in prices.

Note how the MA bounce method works in a daily time frame too; I can visualize four attacks to the SMA(20) during Google’s price ascent, as well as two on descent… very profitable.

Also, note the importance of the 5 day EMA as an early warning that something is amiss, – the canary in the mine.
This property, plus the fact that it is trailing prices allows us to use the EMA(5) (with adjustments) as an important protective stop for short term trades.

Longer term trades should allow for some short term noise, hence MA protective stops are placed closer to higher MAs; EMA(20) and EMA(50), for instance. However, allowing prices to pierce an EMA(50) without exiting a position is foolish, – it means something is awfully wrong, and prices will have to conquer too many MAs to recover its lost strength and trend.