Figure 6.7
shows the application of the Eight Rules on the crossovers between an 8-day moving average and a 34-day moving average as well as the plot of a momentum oscillator between the two moving averages. When the 8-day moving average crosses above the 34-day average, the oscillator will be above the zero line.
FIGURE 6.7
The top window displays examples from the Eight Rules principle between the interplay of an 8-day moving average and a 34-day moving average. The bottom window shows the
overbought zone and oversold zone of the momentum oscillator, which is derived from the difference of the two moving averages.
Referring to the Eight Rules, if another moving average is plotted between price and 200-day average, say a 50-day average, there will be two moving average crossovers, a 50-day average and a 200-day average.
The interplay of these two moving averages, 50-day and 200-day, is popularly used in considering prospective bull and bear markets. When the 50-day is above the 200-day, the market is considered to be in a long-term bull phase, and when the 50-day is below the 200-day, the market is considered to be in a long-term bear phase. When the 50-day crosses from below to above the 200-day, it is referred as the Golden Cross, signaling a market change to a bullish outlook, and when the 50-day crosses from above to below the 200-day, it is referred as the Dead Cross, signaling a market change to a bearish outlook.
Generally, the combination of two moving averages is effective as well as easy to interpret.
The faster line tracks the shorter-term trend, while the slower line tracks the longer-term trend.
When there is a crossing between the faster line and the slower line, it indicates a probable change in trend. This method of crossover is commonly used in developing automated setup conditions, and in a rule-based trading system, which will be discussed in later chapters of the book. However, this system alone is subject to whipsaws in a bracket market condition and should be supported by a subsequent entry condition or by another supporting oscillator.
In a crossover system of two moving averages, we have three factors: the price, a short-term moving average, and a long-term moving average. Let’s take the price as the closing price, the
short-term moving average as 50-day, and the long-term moving average as 200-day. In a bullish trend, the alignment of these three factors (from top to bottom) will be: price, 50-day, and 200-day; the price will be above its 50-day line and the bottom line will be the 200-day. In a bearish trend, the order is reversed, with the 200-day at the top and the price at the bottom.
When the price is between the 50-day and the 200-day, the interpretation becomes less obvious. Under such conditions and subject to other supporting technical analysis, we may want to stay on the sideline until the situation improves, unless an automated trading system is being used.
What is being described so far refers to the application of 50-day and 200-day moving averages in a daily chart. If it is a weekly chart, the time frames for the averages will have to be changed to 10-week moving average (equivalent to 50-day moving average) and 40-week moving average (equivalent to 200-day moving average), as shown in
Figure 6.8
. In a weekly chart, the Golden Cross refers to the crossing of 10-week average above the 40-week average and the Dead Cross refers to the crossing of 10-40-week average below the 40-40-week average.
FIGURE 6.8
Weekly chart of the Hang Seng Index showing the Dead Cross on March 7, 2008 and the Golden Cross on May 22, 2009.
Figure 6.8
is a weekly chart. It shows the application of the Eight Rules of moving average crossovers between the 10-week moving average (that is 50-day moving average in a daily chart) and the 40-week moving average (that is 200-day moving average in a daily chart). The right-hand side of the chart shows the market entering a bracket condition as indicated by both of the averages going horizontally. In such market conditions, we see whipsaws between the 10-week and 40-week line.
Figure 6.9
shows a possible pattern of movements among the three factors, from a bullish condition to a bearish condition and back again to a bullish condition.
FIGURE 6.9
Movement patterns of price and two moving average lines.
With three averages, there will be four factors. Using the preceding example, we add another medium-term average of 90 days. The moving average system will now consist of price, 50-day, 90-day, and 200-day averages.
Figure 6.10
shows the Queuing Theory of directional movements of price and moving averages.
FIGURE 6.10
Movement patterns of price and three moving average lines.
There are various scenarios for the interplay of price and its three moving average lines.
Figure 6.10
is one of the scenarios showing the alignment order of the relationship of averages and price. Subject to the volatility of prices, the various respective movements do not necessarily move at an orderly pace as shown in the table. Prices could traverse the average lines at the same time. (See
Figure 6.11 and Figure 6.12 .)
FIGURE 6.11
Daily chart showing the interplay of three moving averages and price from a downward trend to an upward trend, and then to a bracket market.
FIGURE 6.12
Daily chart showing the relationship of price and its three moving averages, the 50-day, 90-day, and 200-day lines, are a guide to the longer-term outlook of the market. The crossings between the 90-day and 200-day averages confirm the validity of the Dead Cross and Golden Cross. The crossings between the 50-day and 90-day averages act as setup positions and will alert a technician to a possible change of trend.
Based on the scenario shown in Figure 6.11
and Figure 6.12
, the setup for a bearish trend is when the price is below both the short-term (50-day) and medium-term (90-day) averages, and the 50-day crosses below the 90-day. The setup for a bullish trend is when the price is above the short-term (50-day) and the medium-term (90-day), and the 50-day crosses above the 90-day. In a crossover of two averages, take note of the slope direction of the longer line. In a bullish crossover, the longer average line should either be rising or moving in a flat, while in a bearish crossover, the longer average line should be moving downward or in a flat direction. The setup position is vulnerable to false breaks when prices go into a consolidation phase. When the 50-day is below the 90-day, and the 90-day is above the 200-day, it confirms continuing downward trend of price; and, vice versa, when the 50-day is above 90-day and 90-day is below 200-day, it confirms the continuing upward trend of price.
The advantage of using a three moving average system is that it provides a wider perspective of market directional movements. For example, when the longer-term moving averages are not in a queue of bullish alignment, any rally signals by the crossovers of shorter-term moving averages will be short-lived.
The preceding are examples of how to read the probable trend of the market in the relationship of movements in different moving averages. It is possible to add more averages to the combination, which gives even more possibilities of movements, and these can be split up into sets of long-term and short-term moving averages. The set of long-term averages will serve as the indicator of the overall trend, and the set of short-term averages will serve as the entry and exit signals of the overall direction of the main trend, as shown in
Figure 6.13 .
FIGURE 6.13
Two sets of moving averages at work. The pair of short-term averages acts as entry and exit signals for the overall market, as indicated by the set of long-term averages.
There are many ways of using moving averages to trade. Using crossovers of averages to trade may be the easiest mechanical system, but the method can baffle traders because the effect from a set of moving averages crossovers does not apply consistently to price behavioral patterns. This appears to be more discernible in the application of longer time frame averages—for example, the crossovers of 50-day and 200-day moving averages.
Let’s examine a chart of the Shanghai A Share Index ( Figure 6.14
). The lower window of the chart is the index, with a set of three long-term moving averages:
the 50-day, 90-day, and 200-day averages. The upper window shows two oscillators: the line plot of price to its 200-day moving average, and the histogram of the 50-day moving average to the 200-day moving average. When price crosses above its 200-day moving average, the line plot will be above the centerline. And when the 50-day average crosses above the 200-day average, the histogram bar will be above the centerline. They are both momentum plots. The oscillator plots could be construed as the comparative momentum between the shorter-term line plot and the histogram, or the longer-term period.
FIGURE 6.14
Comparative crossing of a set of long-term moving averages.
There are three points, 1, 2, and 3 as marked in the chart, which are worth looking into. Point
2 is a common pattern of moving average crossovers inside a contracting triangle. The index broke slightly below the 200-day on January 28, 2010, at about point “d” toward the end of a contracting triangle (marked as a, b, c, d, and e), and managed to cling fast and vacillate around its 200-day average. On March 23, 2010, the bearish sign appeared: the 50-day average dipped below the 200-day average. But instead of declining, the index made further advances until April 19, when support finally yielded to selling pressure. The advance by the index following the bearish crossing of the 50-day and 200-day averages was a false move. The three longer-term averages, 50-day, 90-day, and 200-day, were not aligned in a sequential order.
Incidentally, the sharp drop on April 19 also saw the beginning of the destruction of the consolidation pattern, a pattern formed by the contracting triangle when the index finally went below the mirror trend line of TL1 toward the mirror line of TL2-1.
Point 1 and Point 3 are good examples of how price reactions can be contradictory when the 50-day average crosses above the 200-day average. In the first example, at Point 1, the index went above the 200-day average on March 23, 2009, for the first time after a long decline of approximately 14 months. And at X1 on April 9, 2009, the 50-day average pushed above the 200-day average, paving the way for the index to make a small bullish run to early August. In the second example, at Point 3, the index crossed above the 200-day average on October 12, 2010 after a six-month decline. And at X2 on November 10, the 50-day average made a crossing similar to the first example moving above the 200-day line. If a trade had been executed on the assumption that a bullish run would follow as in the first example, the result would have been disastrous because the index made a U-turn downward the next day and fell sharply. There was no follow-up bullish run.
What exactly happened? At Point 1 on March 23, 2009, and at Point 3 on October 12, 2010, the index crossed above the 200-day average, which was followed by the 50-day average crossing above the 200-day average on April 9, 2009 (X1) and November 10, 2010 (X2), respectively. In the first example, the 50-day crossover generated a small bullish trend, but in the second example the 50-day crossover did not generate any bullish follow-up trend. The difference in the effect of the two crossing is in the strength of the index’s trend at the time of crossing. When the 50-day average crossed the 200-day at X1, the index broke out of a bullish reversal pattern, but at X2, the index was entering into a bearish diagonal pattern. Thus, at X1, the strength of the trend is stronger than at X2. At X2, the index is subject to heavy resistance as it has reached the center of a saturated area of resistance, the contracting triangle (a-b-c-d-e). It has retraced over 61.8 percent of the decline from P to Q and 100 percent of the recent decline from “e” to Q, and at X2 its strength has weakened. This is noticeable by the negative divergence between the 200-day price oscillator and the index. Such divergence is often overlooked by novice traders.
Rule 1 and Rule 5 of the Eight Rules on the Interpretation of Price to Moving Averages can be applied to moving average crossovers between a shorter-term and a longer-term average. For easy reference, we have repeated the two rules below and substitute the word “price” with
“50-day average” in the rules.
Rule 1: If the 200-day average line flattens out or advances following a decline, and the 50-day