Using moving averages to target the trends

October 20, 2013 07:00 PM

Every market has its time, including stocks. This is the basis of trend trading. At any given time, some stock or market sector is appreciating or declining steadily in price. These trends embody significant profit opportunity for traders, offering relatively large rewards with comparatively little risk with respect to other strategies.

However, the task is not so simple. Traders must not only find the right stocks or market sector exchange-traded funds, but they must execute a disciplined approach to trading them. Many traders miss profit opportunities because of fear.

Fear is a mental anchor that feeds a disbelief that the trend won’t continue. In the mind of the trader, either the stock has risen or fallen too much. It has left no more room for predictable price change. However, most of the time, the trend continues and opportunity is missed. These missed trades usually are when a smaller trend of the larger move breaks. 

Trend trading does not have to be complicated. There are a number of tools available to identify when stocks are making an extended move. One such approach might include the following technical conditions to qualify an uptrend:

  • The stock is above the 21-, 50- and 200-day moving average
  • The stock has started moving up after a long period of consolidation
  • The stock is making new highs on the six-month or 52-week time frame

Consider “Time to move” (below). The Indian stock La Opala RG’s behavior depicted here is illustrative of how individual equities move no matter the market. As we see, it went through a long phase of consolidation from February 2012 to July 2012, with the major moving averages getting squeezed in that period.

In August, however, the stock started moving upward. It ultimately appreciated around 400% in the next year. Clearly, the larger trend was bullish. As price followed this bias, we saw sharp rises followed by a small period of consolidation and then more moves higher.

The blue lines are trendlines that were drawn from the high point of the candlestick that formed as a result of a solid upmove. The trendlines have been connected to the tops of a few more candlesticks that created resistance. Once the resistance broke, there was a fresh rally higher.

We can see similar movement in Domino’s Pizza Inc. (see “Parabolic push,” right). The stock broke out above its 52-week high and the 21-, 50- and 200-day moving average on the three-day chart in early 2010. Since then, it has risen close to 700% in just three years. Throughout this rise, the stock offered trading opportunities after phases of consolidation, and the breakout would see rallies of 10%-15% with the stock finding support at the 21-day moving average. The stock did break the 21- and 50-day moving average, but later rallied further. 

Lumber Liquidators Holdings provides another classic example of a stock breaking into a sustained trend (see “Run and gun,” right). The stock had consolidated within a rising channel for the latter half of 2011. In 2012, it broke above the range and started a rally that had periods of short trends and consolidations. Once again, the breakouts from the consolidating patterns gave the stock a 10%-15% upmove in a short span of time, usually just three to four days.

The consolidation would then go on for a month, after which the uptrend would resume. The stock was creating higher highs and a future support level. It gave a break from the $48 resistance in September 2012, and later on that resistance became a crucial support that twice gave the stock a bounce from those levels. Thus, the uptrend continued.

In trend trading of this nature, the best opportunity for trades comes when there is a pop followed by a consolidation. The creation of this temporary resistance and then the breaking of it provides the short-term momentum that allows traders to make solid returns over short periods.

When the subsequent consolidation occurs, fear sets in, however, and traders find it hard to believe that the market could have another surge higher (or lower). It’s the culmination of these moves, though, that results in gains of 50%, 100% or even 200% in just a matter of a few months.

It’s simple. The uptrend in the stocks exists as long as they are above the 21-day and the 50-day moving averages. Still, price moving below these averages alone can’t be an indication of trend reversal. A better and more accurate indicator is when the 21-day actually crosses below the 50-day while price remains below the averages.

One observation in these trending stocks is that they find support and consolidate roughly 5% around the zone where the 21- and 50-day moving averages start to overlap. This creates a good base for the stock that becomes strong support for the future. Once the stock breaks out of this consolidation zone, with the 21-day above the 50-day, a new phase develops and opportunities arise.

In many cases, these moves are accompanied by what some consider a counter-trend indicator — an overbought reading in the relative strength index (RSI). In cases of strong trend moves, the RSI might remain overbought while the stock continues to create new highs. The chart of the Indian stock market index, the CNX-FMCG, shows us an excellent example of this (see “Buying on strength,” below).

Traders should ask themselves why stocks tend to trend in this manner, making new highs repeatedly over time. Reasons might be: 

  • Fundamentally, the stocks are part of undervalued sectors
  • The stocks have consolidated because of low volumes or little fund interest

Once the relevant fundamentals change — or the government comes out with some favorable policies — these sectors attract money from institutional investors because of under-valuation and brighter future prospects. With so much money flowing in and new buyers being attracted, the rally is here to stay.

Risk control

A trader who sells a falling stock or buys a rallying stock has invested in the likelihood that the trend will continue. A trader who buys a falling stock or sells a rallying stock has bet on a reversal in the larger trend. Of course, reversals happen, but over time the safer bet is to go with the trend rather than assume the moment you make your trade is one of those rare moments when price turns.

“Down and out” (below) shows the market price of Indian steel giant Jindal Steel. This stock has been in a bearish trend from the beginning of 2013, with some pullbacks seen in between. The stock hasn’t managed to close above the 21-day moving average, and every time it comes near it, selling pressure is seen and the stock drifts lower.

Jindal saw a sharp sell off in June and then later consolidated for a greater part of July. Resistance formed and provided some trading opportunities. A trader going with the larger trend would have shorted it around 230 and waited for the stock to fall, but a trader who bet on a trend reversal would have bought it and waited for 230 to break. This is a key price, both in terms of resistance and moving average vicinity.

If the trend on a larger time frame is bearish, then trades should be taken with a bearish view around the resistance levels. If the trend is bullish, then the trades should be taken with a bullish view once the resistance on a smaller time frame breaks.

When a trade is taken on a breakout basis and the price is above the 21-day moving average, positions should be held until the price breaks the average. In most cases, these positions are held for one to two months. Traders should maintain a stop loss shortly below the moving average, but if the risk involved is greater than 7%, consider a dollar-based stop instead — one that better fits a more conservative risk appetite. Short-term traders can use a stop loss of a close below the candle that provides the breakout confirmation.

Trend trading is an important tool for all stock traders to have in their arsenal. The benefits are that trending stocks move in one direction steadily; there is little confusion over the direction of price. When timed correctly, profits come quickly. Generally, trend moves are supported by strong fundamental underpinnnigs.

Of course, this approach isn’t perfect or foolproof. Downsides of this strategy are that it’s tough to decide on proper profit targets and stop losses. As quickly as profits appear, they also can disappear. Plus, breakout trend moves can be missed easily, particularly by traders paralyzed by fear. Once gone, it may be some time before a trend opportunity re-presents itself.

Raghav Behani is a trader and investor in the Indian stock markets. Reach him via his website

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