Trading Basics—The MA Cross Signal - Wanderer Financial - Stock Trading Newsletter for the Wandering Soul

Trading Basics—The MA Cross Signal

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Stock Trading

The market provides different opportunities for different time frames. Some traders prefer to focus on the very long-term trend, while others look at the short or the intermediate-term movements for trades. For most traders, it makes sense to focus on the multi-month intermediate-term trends. These would be akin to a surfer catching a wave vs. a shorter term price fluctuation which would be more like a ripple. The technical tools we use depend on the time frame we intend to trade.

Extremely long-term investors might look at a “death cross” as a sell signal and a “golden cross” as a buy signal. For a death cross to occur, the 50-DMA must cross below the slower moving 200-DMA. A golden cross signals an entry when the 50-DMA (blue in the chart below) crosses above the 200-DMA (gold). Looking at the chart below, you can see the death cross signaled a trader to exit the Dow in December of 2007 and remain on the sidelines all the way to June of 2009. By following this signal, a trader would be out of the market entirely for a year and a half and would have been spared the bulk of the bear market. The golden cross catches the majority of multi-year trends, but often misses the multi-month fluctuations within a secular trend. Due to the length of the holding period, this style of trading usually involves non-leveraged ETF’s.

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To catch the medium term “waves” within a long-term trend, the moving averages need to shorten enough to catch the bulk of a wave’s move. While different sectors have different levels of volatility, we have found the 9-day exponential moving average and the 20-day simple moving average to be very effective for catching the bulk of most waves. By waiting for the 9-EMA to cross above or below a flattening 20-DMA, we increase the likelihood that we are entering a trade early in a trending move, and not merely reacting to a ripple, or multi-day fluctuation within a trend.

On the chart below, we replaced the 50- and 200-DMA with the 9- and 20-DMA, but we left the arrows that marked the death and golden cross for reference. You can see how the 9/20 cross caught five medium-term uptrends that were missed by the 50 and 200-DMA’s. You can also see upon close inspection that it provided a couple of false signals. The shorter the moving average, the more responsive it will be to short-term price fluctuations and therefore the more likely it will provide false signals. These entries were quickly reversed at a small loss. Since this technique catches the shorter trends, leveraged and inverse ETF’s are suitable.

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But what if we want to trade the ripples? Active traders looking for opportunities that only last a few days to a couple of weeks will find that even the 9/20 crossover is too slow to catch short term ripples. For more active trading, we shorten the moving averages even more and often rely on what we call the 6/20 TEMA, or 6-day triple exponential moving average and 20-day exponential moving average.

On the chart below, we kept the landmarks for where the 50-DMA crossed the 200-DMA, and also kept the circles where the 9/20 signals were. On this chart, we replaced the 9- and 20-DMA with a script that shows the 20-EMA, and prints a green arrow whenever the 6-TEMA (triple exponential moving average) crosses above the 20-EMA, and a red arrow when it crosses below. Notice how many more signals it provides? You will also notice that more signals aren’t ALWAYS better, and several entries would result in small losses. This is effective for trading stock and stock options with stops being moved up aggressively.

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So which combination of moving averages is best? To that question, there is no right answer. It depends on how active a trader wishes to be. All of them would have kept you out of the bulk of the bear market during the financial crisis. The big difference is that the shorter MA’s provided long and short trading opportunities in a bear market, where the 50/200 MA simply kept you out of the market for a year and a half. Leveraged and inverse funds are ill-suited for long time frames, so the choices for trading the 50/200 are either non-leveraged funds or cash. That means there would be little opportunity to make money in a bear market, but you aren’t losing money either.

Since leveraged ETF’s decay much slower than options do, they are better suited for trading the 9/20 trading signal. With the wide variety of leveraged and inverse funds currently available, it is possible to make money on the long and short side of the market. For individual equities, the 9/20 provides a long signal, but there are no ETF’s on one specific stock, so to trade a dropping market, you have to use inverse index ETF’s. Luckily, there are plenty to choose from.

Using the 6/20 TEMA provides the most trading opportunities, but it also provides more false signals that can mentally take a toll on a trader that isn’t accustomed to shrugging off small losses in search of the more significant moves. On the other hand, the time frame is shortened enough that options are suitable, which significantly increases the leverage available. Since options are available on individual equities, it is also possible to trade the short side of individual stocks instead of entire sectors.

Which system you use partly depends on the time you are willing to allocate to trading, and partly to your personality. A trader that enjoys being active and is easily able to shrug off multiple false signals can do well in bull or bear markets with options using the 6/20 TEMA, while a trader that prefers to trade indexes via leveraged ETF’s will find the 9/20 more useful. Finally, the investor that prefers to look at the market weekly or monthly will find the 50/200 to be a helpful signaling tool for the few trades it signals per decade.

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