How you can find high probabiliy trading opportunities using moving averages

MOVING AVERAGES

Highest Probabil ityOpportunities:

the

HOW TO TRADE

EWI eCourse Book

How to Trade the Highest Probability Opportunities: Moving Averages

By Jeffrey Kennedy, Elliott Wave International

Chapter 1 – Defining the Moving Average and Its ComponentsA rundown of different types of moving averages and how to use a dual moving average crossover system

Chapter 2 – The Most Popular Moving AveragesThe specific moving average systems that stock and commodities investors use

Chapter 3 – Moving Averages and the Wave PrincipleHow moving averages can help you see wave patterns more easily

Chapter 4 - How To Trade Using Moving Average CompressionHow to recognize and use one of the most dynamic analytical trading opportunities

Chapter 5 - Determining the Trend with Stoplight Trend AnalysisHow to identify whether a trend is up, down or non-existent with Jeffrey Kennedy’s Stoplight trend analysis system

Chapter 6 - Questions and AnswersJeffrey Kennedy answers questions asked by How to Trade the Highest Probability Opportunities: Moving Averages webinar participants.

IntroductionMy name is Jeffrey Kennedy, and I’m the editor of Futures Junctures, Elliott Wave International’s premier com-modities forecasting service. In this course, I will teach you how to use moving averages to trade the highest probability opportunities. By the time you have finished the course, you will know (1) what a moving average is and which ones are the most popular; (2) how to use moving averages to identify Elliott waves; (3) what my favorite moving average trade set-up is; and (4) how to use Stoplight trend analysis, an easy-to-understand technique for deciphering market trends.

Editor’s note: This webinar was originally presented live on August 13, 2008.

1How to Trade the Highest Probability Opportunities: Moving Averages© 2009 Elliott Wave International — www.elliottwave.com

http://www.elliottwave.com

Chapter 1 Defining the Moving Average and Its ComponentsA moving average is simply the average value of data over a specified time period, and it’s used to figure out whether the price of a stock or a commodity is trending up or down. Although simple to construct, moving averages are dynamic tools, because you can choose which data points and time periods to use to build them. For instance, you can choose to use the open, high, low, close or midpoint of a trading range and then study that moving average over a time period, ranging from tick data to monthly price data or longer.The most common types of moving averages are simple, exponential, weighted, smooth, centered, adaptive, and triangular. Of these, the three most often used by traders and analysts are the simple moving average, expo-nential moving average and weighted moving average, so I will refer to them often throughout this course.

Figure 1-1Figure 1-1 plots three moving averages on a daily chart for Corn. The red line represents a 10-period weighted mov-ing average, the green line represents a 10-period exponential moving average, and the blue line is a 10-period simple moving average. Without going into a long discussion of the math behind these moving averages, I want to point out that the exponential moving average and weighted moving average put more value on the front end, which means that while a 10-period simple moving average assigns the same weight to each period, exponential and weighted moving averages put more weight on the most recent data. As you can see in Figure 1-1, the varia-tion is noticeable but not enough to make a big difference in their representation. I have worked with all types of moving averages over the years, and I rely mostly on the simple moving average, because simple things usually work best. In this course, I will focus most on the 10-period simple moving average.

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Chapter 1 — Defining the Moving Average and its Components

How to Trade the Highest Probability Opportunities: Moving Averages© 2009 Elliott Wave International — www.elliottwave.com

The Dual Moving Average Crossover System When designing a trading system using moving averages, most people will begin with a dual moving average crossover approach, as shown in Figure 1-2. The 5-period simple moving average is shown as a thin blue line. The 10-period simple moving average is the thick black line.In analysis and technical studies, you’ll often see a chart marked like this, and you will also see some exciting price moves as a result. Look at how the two lines cross over one another at the top of the chart, indicated by the red arrows to the downside. These red arrows indicate that the 5-period simple moving average crossed below the 10-period simple moving average.

Figure 1-2At first, you might think, “Wow, that looks like a great trade.” Since the trendline break gave a signal, you figure you would have been short and made lots of money. However, what you need to realize is that a moving average is actually a trend-following indicator: it always lags the market. This means that whenever the market is trending, such as during the periods marked with a blue line, moving averages work nicely to give you worthwhile signals.

Figure 1-3But they can also give you false signals, particularly when you enter a sideways market or a market where there’s no trend, circled in Figure 1-3. From all my years of testing moving averages, I have learned the hard way that there is no one magic moving average setting. There is no period that works across all markets and time frames.

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Figure 1-4So, if you’re interested in optimizing a market according to a moving aver-age or a moving average crossover approach, I recommend the following actions:

1. First, identify the specific market and time frame you want to study, such as Corn on the daily level.

2. Second, make sure the period you are initially testing con-tains both a trending phase and a non-trending phase. This step will ensure that your results do not include a trend bias.

3. Then perform a simple optimization to identify which moving average parameters are best to use.

4. Once you complete those steps, you will then want to examine a totally different period of time, some-thing that may have occurred months or even years ago. This step is extremely important because it is similar to what some refer to as a Double-Blind study. In the “biz,” it is referred to as Out-of-Sample Data testing, the result of which will determine if you have identified a viable mechanical trading system.

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Moving Average Price Channel System Figure 1-5One way to overcome whipsaws or false signals with a dual moving aver-age crossover system is by employing a moving average price channel. The moving average, the higher black line in Figure 1-5, is a 20-period simple moving average of the high. The lower black line is the 20-period simple mov-ing average of the low. The moving average price channel is the area in be-tween. The blue line is a 5-period simple moving average of the close. In Figure 1-5, the buy and sell signals are marked with arrows. A buy occurs when the 5-period simple moving aver-age of the close, or the blue line, crosses above the upper boundary line of our price channel. A sell is when the blue line crosses below the lower line, or the 20-period simple moving average of the low.Using a price channel cuts down on the number of whipsaws because it creates a more significant hurdle for prices to overcome before a signal is generated. In the same figure, notice that since the move up began in late March 2008, there were buy signals to the upside, as well as a nice move to the downside, which signaled the short seen here in Corn. When designing a mechanical trading system using moving averages, dual moving averages or moving aver-age channels, it is important to remember that what may work in Corn may not work as well in the Canadian Dollar and vice versa. Again, there’s no magic setting.

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Combining the Crossover and Price Channel TechniquesFigure 1-6Another way to work with moving aver-ages is to combine the crossover tech-nique with the price channel technique. The price channel system is shown on a chart of E-mini S&P 500 in Figure 1-6. The green arrows identify when the blue line crosses the 20-period moving aver-age of the higher line, which is a 20-pe-riod simple moving average of the high. The red arrows indicate a close below. The circled diamonds indicate when the 5-period moving average crossed below the 10-period. (In an attempt to make this price chart easier to interpret, I have not shown the 10-period simple moving average.) Essentially, this method combines the best of two moving average systems into one. Its purpose is to give you a slow entry using the moving average price channel system, which eliminates false trading signals, but a quick exit to protect profits by using a dual moving average crossover system.

Figure 1-7To further explain this methodology, look at the Net Logic stock chart in Fig-ure 1-7. See the circled green arrow and the circled red diamond, which indicate a slow entry but a quick exit. If I had to pick between a dual moving average crossover system versus a price channel system, I would favor the price channel system, because it more easily identifies areas of support where you can expect trend reversals.

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Figure 1-8In Figure 1-8, notice how the market – and especially the moving average – dipped into the price channel and then turned back up, which is marked with the first small vertical line. This is an excellent indication of a countertrend move within a larger upturning market. Then the same thing happened again, marked by the second small vertical line.

Figure 1-9Figure 1-9 is an updated price chart of the same stock. In the downside within the stock’s sell-off, prices pushed into the price channel and then turned back down, and you can see the successful break of the price channel on the far right of the chart. From there, let’s as-sume the price channel continues higher. From a trading perspective, I would consider this situation to be a buying opportunity for a move above the ex-treme, especially if prices pulled back into the channel and then began to turn back up, because this is the signature of a countertrend move within a larger uptrending market.

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Figure 1-10This chart of Corning in Figure 1-10 shows how each time the market moves into the price channel (marked by the short vertical lines), it signals a buy-ing opportunity. When Corning’s price breaks through the price channel (in-dicated by the short diagonal line), the trend has turned to the downside. So, we have a clear uptrend followed by a clear downtrend. This moving average price channel identifies countertrend moves with an uptrending market. Notice how the blue line keeps revisit-ing the 20-period moving averages of the high or 20-period moving average of the close.It’s very similar to Elliott wave analysis, where impulse waves consist of five moves and a three-wave correc-tion. Buying opportunities are in wave 2 and wave 4, and there’s a selling opportunity at the top of wave 5, which you can see from the wave pattern drawn below the stock chart.

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Chapter 2The Most Popular Moving AveragesIn this section, I will explain the moving averages that are most popular on the Street, both for the stock ex-changes and the commodities markets. Among technicians who work mainly with stocks, the most popular moving average is a 50-period simple moving average of the close and a 200-period simple moving average of the close. In fact, these settings are so popular that you may have even heard them referred to by technical analysts on CNBC.

Figure 2-1Figure 2-1 shows an example of when the 200-period moving average provid-ed resistance in an April-to-May move up in the Dow Jones Industrial Average (circled on the heavy black line). As you can see, the 50-period moving average provided support (circled on the blue line).

Figure 2-2Notice in Figure 2-2 how the 50-period moving average provided resistance in a daily time frame, as marked by the short, red vertical lines. But you can also see how the Dow penetrated the 50-period simple moving average line decisively and pushed up higher. That’s a good example of why you should remember that although moving averages can be a wonderful tool, these little blue and black lines can also become ropes that tangle you mentally and emotionally if they’re misused.

Chapter 2 — The Most Popular Moving Averages


Figure 2-3For other markets, such as commodities and currencies, it’s the 10-period and 40-period simple moving averages that are popular. In Figure 2-3 of Sugar, you can see how the 10-period moving aver-age crossed below the 40-period moving average line and then came back to mod-erately test it before reversing sharply to the downside (marked by the red line). Some commodity traders highly value the 10-period simple moving average of the close and the 40-period simple moving average of the close.

Figure 2-4Now, let’s look at another popular set-ting with regard to a weekly time frame that I like: It’s a 13-week setting. One way to think of a moving average is that it’s an automated trend line. This Sugar chart features a 13-week simple moving average of the close on a weekly time frame, in Figure 2-4. The 13-period simple moving average of the close works equally well in commodities, currencies and stocks. In this chart, prices crossed the line (marked by the short, red vertical line), and that cross led to a substantial rally. This chart also shows a whipsaw in the market, which is circled. Later, I’ll explain a tool that might help you overcome whipsaws like these where the market gyrates up and down almost in place.



Figure 2-5Another popular moving average setting that many people work with is the 13- and the 26-period moving averages in tandem. Figure 2-5 shows a crossover system, using a 13-week and a 26-week simple moving average of the close on a 2004 stock chart of Johnson and Johnson. Obviously, the number 26 is two times 13. During this four-year pe-riod, the range in this stock was a little over $20.00, which is not much price appreciation. This dual moving average system worked well in a relatively bad market by identifying a number of buy-side and sellside trading opportunities.



Chapter 3Moving Averages and the Wave PrincipleIn this section, I will show you something you may not have known about moving averages. You can use them to identify Elliott waves. In fact, if you’re new to the Wave Principle, I recommend using a moving average to get you started, and the reason why is that a moving average overlaid on a price chart will help train your eye to see developing Elliott wave patterns.

Figure 3-1For an example of a schematic Elliott wave, look at Figure 3-1. If you’ve read The Elliott Wave Principle by Robert Prechter and A.J. Frost, you know that wave patterns are illustrated as line diagrams.

Figure 3-2When you look at a real price chart rath-er than a schematic, the basic chart is typically an open-high-low-close price chart. Each price bar represents a single period and is illustrated by a vertical line with a small mark to the left and a small mark to the right as seen in Figure 3-2. The little lower line on the left-hand side of the vertical bar is the open; the little upper line on the right-hand side of the vertical line is the close; the top of the line is the day’s high or that trading period’s extreme; and the bottom of the line is that trading period’s low. Here’s the thing: Whenever you’re making the transition from looking at a textbook diagram to actually counting Elliott waves on a real price chart, it can be confusing to the eye. If you use a moving average, it will help you to see the wave pattern more easily.

Chapter 3 — Moving Averages and the Wave Principle


Figure 3-3Let me prove my case more thoroughly with this chart of Corn. In Figure 3-3, the blue line is an 8-period simple moving average of the close, which clearly shows that a five-wave decline has unfolded from the upper left-hand side of this price chart. With the aid of a moving average, the subdivisions within this selloff are more easily dis-cernible than with the untrained naked eye. Also, notice that the slope of the move up in wave 4 is shallow. This detail is important because one of the key characteristics of countertrend price action is that it moves slowly, thus its slope will be inherently more shallow than what one can expect to encounter when a motive wave is in force.

Figure 3-4This price chart of Sugar in Figure 3-4 exhibits more Elliott wave patterns, which can, again, be seen more clearly by viewing this open-high-low-close price chart along with a moving aver-age. This moving average is still an 8-period simple moving average of the close, though you could also use a 5-period or even an exponential moving average. Again, there’s no magic number when it comes to moving averages. What mat-ters is that you find something you’re comfortable with and that you apply it consistently. If there’s any magic to moving averages that I can share with you, that’s it. Find what you like, find what works for you and apply it consistently.Back to the chart: Notice the three-wave move on the left-hand side of the chart, marked by the labels A, B, and C. Wave A is a move to the downside, followed by a three-wave move up in wave B. Next is a dip, an advance, another move to the downside and a sideways move (wave iv), followed by a press down to complete wave C. Next you can see an advance, another dip down in the moving average and another rally. In fact, you can see waves 1, 2, 3, 4 and 5. The moving average actually helps train your eye to identify the wave patterns that are unfolding.



Figure 3-5In the previous figure, I identified wave 3 within a developing five-wave move. Now, by applying the moving average on a smaller time frame of 60 minutes, you can clearly see the wave 3 subdivi-sions in Figure 3-5.

Figure 3-6If we look at these same price charts on even a smaller time frame, the same clear Elliott waves are present and ap-parent. In Figure 3-6, look at wave 3, followed by waves a and b and the mov-ing average. It comes down, bounces, comes down again, bounces again and comes down one more time, which cre-ates waves a, b, and 1, 2, 3, 4 and 5 of wave c.



Fibonacci Values and Moving Averages Remember that, according to R. N. Elliott’s book, Nature’s Law, the Fibonacci sequence is the mathematical basis of the Wave Principle. The most common Fibonacci multiples for wave three are 1.618, 2.618 and 4.236, this last multiple being a formidable objective for third-wave rallies. Next in the Fibonacci sequence is 6.854. I look for these common multiples when I’m determining how far wave 3 will move in relation to wave 1. The most common Fibonacci retracement for fourth waves is .382. Other frequently occurring retracements are .50 and .618. To determine fifth-wave objectives, remember that waves 5 and 1 are usually equal. A fifth wave can also equal a 1.618 multiple of wave 1 or a .618 multiple of waves 1 through 3. But how does this Fibonacci analysis work with moving averages? Here’s where I would like to introduce my Fibonacci extension tool, which involves using the extremes of moving average values instead of actual price highs and lows.

Figure 3-7Let me show you exactly how to do that on this 240-minute chart of Corn (Fig-ure 3-7). To make projections using the moving average, use the extremes in the moving average (circled), which mark waves 1 and 2. I previously mentioned that 4.236 is a formidable Fibonacci objective for third waves. The pencil points at the 4.236 line, and you can see that the moving average pushed moder-ately below this level before reversing in wave 4.



Figure 3-8 Now the most common Fibonacci re-tracement for fourth waves is a .382 multiple of wave three. However, shal-lower and deeper fourth wave correc-tions occur. And one instance where shallow corrections are quite common is when the larger trend in a market is deeply ingrained. When this is indeed the case, as it is in Corn, a shallow Fi-bonacci retracement can be expected, specifically, .236. As you can see in Figure 3-8, wave 4 traveled to just be-low the .236 retracement of wave 3 of its moving average length.

Figure 3-9 In Figure 3-9, I’m projecting the fifth wave, using the distance traveled in wave 1, which is a common fifth-wave objective. Take the distance the mov-ing average traveled in wave one and project that distance downward from the extreme of the moving average that occurred in wave four. In this instance, the moving average nearly reached the 2.618 multiple of the moving average length that transpired in wave one. Combining this Fibonacci moving average approach with the traditional use of Fibonacci within the context of the Wave Principle makes it easier to identify multiple layers of Fibonacci support and resistance.



Figure 3-10As an overview of how to use moving averages with Fibonacci values, I pro-vide Figure 3-10. To project Fibonacci multiples for wave 3, I measure the distance traveled in wave 1 and extend that distance from the extreme of wave 2. The multiples I use for wave 3 are 1.618, 2.618 and 4.236. Occasionally, I see 2.0, which I’ve put off to the side. Also, the guideline of wave equality states that wave 5 typically equals the distance traveled in wave 1. The next relationship to look at is 1.618, but, depending on the markets and its sub-structure, you may see wave 5 equal a 2.618 multiple of wave 1. There are times when I use waves 1 through 3 to identify fifth waves, especially when the fifth wave extends, as is often the case in commodities. Here are the three relationships to look for:

1. Sometimes wave 5 equals a .618 multiple times the distance traveled in wave 1 through wave 3.

2. Sometimes wave 5 equals waves 1 through 3.

3. Sometimes wave 5 equals a 1.618 multiple times the distance traveled in waves 1 through 3.

Figure 3-11A common problem traders make is to enter a trade too early. This Elliott wave-based moving average approach is one way traders can overcome this problem. While some traders may begin initiating short positions on a break of the extreme of wave 1, identified by the red line in Figure 3-11, it sometimes is beneficial to wait for the moving average to also penetrate the same price level. As you know, moving averages are lagging in-dicators, which is why signals derived from them lag behind current price ac-tion. Even so, this tendency of moving averages to act as a time stop can slow down your trading and prevent you from entering a trade too early.



Chapter 4How To Trade Using Moving Average CompressionsFigure 4-1The moving average compression is my favorite moving average trade set-up and is inspired by the work of Daryl Guppy. Look at the Soybeans price chart in Figure 4-1, which contains six mov-ing averages — 5, 10, 15, 20, 30 and 40 — that represent a different period of time from the short term to the long term. Moving average compression is the point (circled on this chart) where all those moving averages become one, or, as I often say, when they “get married.” Compression is significant because it happens only when different classes of investors with different objectives and time frames think the same thing at the same time. This condition in the market cannot be maintained for long. To explain, let’s say that the 40-period moving average in this example represents a trader with a two-month time frame while the 5-period moving average represents a trader with a two-hour time frame, and so on. It is uncharacteristic for traders who have different investment time frames to agree on anything. So when they do — which will be represented by multiple moving averages becoming tightly bound — remarkable price moves can result. It’s like shaking a can of Coca-Cola and taking the top off — it explodes. That’s how dynamic moving average compression is. In the case of this Soybeans chart, this moving average compression took the shape of a contracting triangle in terms of Elliott wave analysis, and Soybeans pushed up to $16 a bushel.

Chapter 4 — How To Trade Using Moving Average Compression


Figure 4-2Now, look at the Coffee chart in Fig-ure 4-2, which is a great example of moving average compression. In June 2008, all of the lines were bound tightly together, which led to a dynamic move to the upside. The same moving aver-age compression also happened earlier that year.

Figure 4-3Figure 4-3 provides another beautiful example of a moving average compres-sion. Corn prices went from $6.50 to nearly $8 a bushel as a result. Again, notice how tightly the lines are bunched together prior to the explosive price move up. This chart shows the transi-tion from a point of moving average compression to market expansion.



Figure 4-4A and Figure 4-4BJohnson and Johnson is the subject of the monthly price charts shown in Figures 4-4A and B. Notice where the compression is – at the point where all of the moving averages began to come together in the top chart. As a result of this compression, prices moved dynami-cally as shown in the bottom chart.



Figure 4-5 Figure 4-5 is also a monthly price chart, but of the Canadian Dollar. Notice the moving average compression starting in 1996. This happened in this market only once from 1988 through 2006. If you can possibly be patient enough to wait for this kind of move, do so, and you’ll be right more often than not. Overtrading is another problem many traders face; and because moving aver-age compression is infrequent, it can slow down your trading.

Figure 4-6Notice on the far right of this weekly chart of the British Pound (Figure 4-6) that the 40-period moving average didn’t quite get down to where the rest of the moving averages were “getting married.” But we did have everything from the 30-period on down, which means it still counts as a version of moving average compression. Look at the result of the move – a sharp drop – which is why this market condition is my favorite moving average trade set-up. All I have to do is wait for all of these moving averages to come together and form one line. Then I know an op-portunity is coming.



Figure 4-7 Figure 4-7 is a five-minute price chart, primary session, of the S&P e-mini. On this particular Tuesday, all moving averages came together nicely, which signaled that the market was about to make a nice move. As you can see, there was a subsequent sell-off.

Figure 4-8 You can even utilize this technique on a minute intra-day level. Figure 4-8 is a one-minute price chart of the S&P e-mini. Notice that a sizable price move erupted at 1:20 p.m. as a result of the moving average compression that pre-ceded it. Bottom line — when moving average compression takes place, watch out for what’s about to happen. It’s dy-namic. All you have to do is be patient, wait for it to form. And when it does form, be ready to act.



How to Determine Entry and Exit Points for Moving Average CompressionsFigure 4-9 To determine the entry point for a mov-ing average compression trade setup, you will need to look for one of two things – either the point where the range of a price bar encompasses all the mov-ing averages or the point where all the moving average lines form a single line. Notice in Figure 4-9 the red mark that identifies a single price bar whose range encompasses all the moving averages.

Figure 4-10 Once you identify the price bar that includes all your moving averages, make note of that bar’s high and low (Figure 4-10). These levels are impor-tant because they define your breakout levels.



Figure 4-11 When prices close above or below the identified levels, that indicates the direc-tion of the breakout. Notice in Figure 4-11 that the initial close below the red line was an early warning indication of the direction of the break out. From a trading perspective, a trader can take a short position at this time with an initial protective stop at the high of the bar that breaks out or the high of the bar that encompasses all the moving averages.

Figure 4-12 In this instance, a simple exit strategy would be to exit the position on a close above one of the faster moving aver-ages. In the Canadian Dollar, Figure 4-12, a close didn’t occur above the 10-period simple moving average until February 1999, well after a month-long collapse in this currency.

SummaryTo use moving average compression as a trade setup, wait to identify a bar that encloses all 6 or 10 or 15 moving averages, whatever the number you are using may be. Play the break-out against the high or the low of the bar that encompasses all the moving averages. Then, use one of the faster moving averages as a trailing stop.



Chapter 5Determining the Trend with Stoplight Trend Analysis

Moving averages work well in a trending market, but not in a non-trending market. To identify when there’s no trend in the market, I created what I call Stoplight trend analysis, which is a color-coding system that iden-tifies which trend is which. I color the price bars green when the trend is up, red when the trend is down, and yellow when there is no trend.

Figure 5-1Stoplight trend analysis incorporates three moving averages. Earlier, I explained how to use a dual moving average crossover system. Figure 5-1, though, shows three moving averages. The settings for these three moving averages are 5, 15 and 30. I use these settings because they simply represent weeks. The five-period mov-ing average equals one week of trading, the 15-period moving average represents three weeks worth of trading, and the 30-period moving average equals six weeks of trading.

Figure 5-2So, what does Stoplight actually do? The Stoplight technique determines whether the market is trending up, down or not at all, which is important because you don’t want to trade in a non-trending market. In Figure 5-2, I color-coded the bars: green bars (trend is up), yellow (no trend), and red (trend is down). The Stoplight tech-nique indicates when the market is green and good to go; when the market is not trending and to stay put; or when to raise protective stops or lock in profits. Stoplight trend analysis indicates when to play the buy-side in a bull market when the bars are green, or when to play the downside in a bear market when the bars are red. When the bars are yellow, that’s a warning light that says “do nothing.”

Chapter 5 — Determining the Trend with Stoplight Trend Analysis


Figure 5-3Specifically, bars turn green when the 5-period moving average (the green line) is above the 15-period moving av-erage (the yellow line) and the 30-period (the red line), as seen in Figure 5-3. If all three degrees of trend – the 5-, 15- and 30-period – are positive, the trend is up, and I can play the buy-side. Red bars are the opposite. If the green line is below the yellow line and the red line, the trend is to the downside. Then I can sell all day long. When the market is yellow, either the 5-period is less than the 15-pe-riod but greater than the 30-period, or the 5-period is greater than the 15-period but less than the 30-period. I do nothing.This is a really simple technique that uses three moving averages of different scale, period and duration to help answer one of the most important questions any market analyst must ask himself or herself. What is the trend? Is the trend up? Is the trend down? Or is there no trend at all? Because you don’t want to trade in a non-trending market.

Figure 5-4Now, let’s see what an excellent job this Stoplight system does to distinguish between trending and non-trending phases of a market. Figure 5-4 shows the Stoplight system on a monthly price chart of the Dow Jones.



Figure 5-5Going back in time to 1984, the Dow was in a neutral condition, followed by green bars, which is marked with a short red line in Figure 5-5. Then the bars turned gold, which indicated a consoli-dation; often, these gold bars represent corrective or countertrend pullbacks within the larger trend.

Figure 5-6 Then, from 1985 to 1987, prices moved up (Figure 5-6). Red bars were next, followed by another neutral market condition.



Figure 5-7 Then, going forward in time (Figure 5-7), prices moved up in the DJIA, all the way into the 2000 high. Even then, the market gave us some clues: The green bars followed by the gold bars indicated that there was no trend in the market. Then we have a couple of green bars. None of the highs of the monthly green bars were taken out, and we go back to gold. Then there is the first red bar in the market, which led to significant selling more than once. This shows you that sometimes making no trade can be the most profitable trade you can make.

Figure 5-8Also, in Figure 5-8, you can see the small moving average compression that exists in the market (circled).



Figure 5-9Now, let’s shift to a five-minute time frame of the S&P e-mini in Figure 5-9. Again, three moving averages – 5, 15 and 30 – are shown. Furthermore, notice the moving average compression that occurs on this price chart, where all of the lines come together (circled).

Figure 5-10If you look closely at the bottom of this price chart, as shown in Figure 5-10, you can see red bars followed by gold and then green. Again, this is your yellow light – you’re in the period of time when the market is saying, “Whoa, hold on. Don’t do anything. Something’s going on here.” Overall, you can see the transi-tion from a bearish, red-bar downtrend to where the market begins turning to the upside.



Figure 5-11In Figure 5-11, the market’s neutral con-dition is apparent by the gold-colored price bars. And again, this is important information for traders who were long prior to this development, because it is a warning sign that a change in trend could be occurring or that the market is taking a rest. This kind of knowledge helps you to be proactive with your positions. Once the price bars in this example turn, you then know that the prior trend is exhausted and that the immediate trend is now down.

Editor’s Note: If you don’t have color-coding capability on your trading program, please contact your trading program’s customer service department for instructions on how to set it up.

Dual Time Frame Applications and Stoplight Trend AnalysisFigure 5-12You can also use Stoplight trend analysis on two different time frames, as shown in Figure 5-12, a weekly and daily price chart of the Australian dollar. Notice the gold bars on the left-hand chart that formed in early 2008. The color of these price bars indicate that there is no discernible trend in this market at this time and that you should do nothing. Once the price bars turn green, the trend is confirmed as up.



Figure 5-13Next, I’m going to dial down to the daily level, which is the chart on your right in Figure 5-13. Ideally, I’m looking for a green bar on both the daily and weekly time frames. In other words, I want price evidence of an upward trend on both time frames, because if both the weekly trend and daily trend are up, the market is giving you two thumbs up to go long.

Figure 5-14If you’re an intra-day trader, you may you want to try this method on a 5- and 2-minute time frame. In this example in Figure 5-14, it’s the S&P e-mini. Notice the moving average compression in the chart on the right as well (circled). The dual green light situation is created when both 2- and 5-minute price bars are green. The ideal trade setup occurs when the 5-minute trend is green, and you see a transition in the bar colors on the 2-minute price chart going from green to yellow and then back to green. This formation identifies countertrend moves within larger trending markets.If you’re more of a long-term investor than a short-term trader or speculator, look at daily and weekly, or weekly and monthly charts. As you saw in the monthly DJIA chart, the Stoplight tech-nique told you what the primary trend was for a long time.



Last Thoughts on Moving AveragesMoving averages have been around since before the stock market began, but I hope I’ve shown you some new ways to look at them and to apply them. And while it’s exciting to learn about moving average compression by itself, I think that being able to use the Stoplight methodology to identify trending or non-trending markets is, in some ways, brilliant. Also, if you’re new to the Wave Principle, be sure to use a simple moving average to help you see wave pat-terns on price charts. Then, go beyond that by applying measurements based on moving averages and using Fibonacci values to identify high-probability objectives, such as retracements and extensions.



Chapter 6Questions and AnswersQ. Is back-testing the only way to optimize the moving averages for a given market?

Kennedy: Yes. Begin by visually inspecting the market or time frame. For example, if you work with the Canadian dollar on a daily basis, use either the dual moving average crossover approach or the price channel approach (which is the one I prefer). For example, if you examine the Canadian dollar 10 to 15 years back in five-year increments, you should be able to find a mean that works. Back-testing is strenuous and laborious. It’s easier if you have a good program to help you, such as Genesis Navigator or Trade Station.

Q. Do most trading programs have the formulas for simple moving averages to chart the highs and lows?

Kennedy: Most charting platforms, such as Ninja Trader, Super Charts, Meta Stock, etc., have moving average capability. To create a moving average channel, change the setting in your program from the moving average of a close to the moving average of a high.

Q. Can I open trades in one time frame and determine the trend in another?Kennedy: Yes, you can.

Q. In a downtrend, should I wait for yellow bars on the 5-minute chart before going short? Kennedy: Green bars mean that the trend is up, yellow bars mean that the trend is neutral, and red bars mean that the trend is down. The idea behind the methodology is to always trade in the direction of the trend and to use countertrend moves as buying or selling opportunities. For example, if the 15-minute and 5-minute both show red bars, it means that both the long-term and short-term trends are down. Then, what I like to see is the 5-minute bar color go from red to yellow to green. When the bar color turns back to red, which is in agreement with the longer-term time frame, I believe the market is offering a shorting opportunity.

Q. What do I select for a longer time frame, and how do I resolve conflicting trends?Kennedy: I like to use 1-to-3 or 1-to-4 ratios when using a dual time-frame approach. So if you trade off the five-minute, use the 15- or 20-minute price charts to determine the trend. Regarding conflicting trends, if the longer time frame is down, I avoid buy signals (basis: the five-minute chart) against the trend and use those signals as exit points.

Q. On the daily chart, do I use the shorter time frames for buy signals?Kennedy: If the trend is up (basis: the daily price chart), then you’ll look for buy signals based on the shorter time frames, such as 60 minute or 120 minute.

Q. Can line charts serve as well as moving averages for labeling Elliott waves?Kennedy: Line charts are fine. The reason I use moving averages is to reduce noise from up and down movements in prices.

Q. How do I set the moving averages?Kennedy: All of the moving averages I used were set for the close. The bars are colored based on the averages, not price. So use this formula: 5 sma < or > 15 or 30, etc.

Chapter 6 — Questions and Answers


EWI eBook

How to Trade the Highest Probability Opportunities: Moving Averages

By Jeffrey Kennedy, Chief Commodities Analyst, Elliott Wave International

© 2009 Elliott Wave International

Published by New Classics Library

For information, address the publishers:

New Classics LibraryPost Office Box 1618

Gainesville, Georgia 30503 US

www.elliottwave.com

ISBN: 978-0-932750-85-3

http://www.elliottwave.com

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How you can find high probabiliy trading opportunities using moving averages