To begin we will define the intermediate trend and to do this we can use a simple moving average line. We will then look at the price line in relation to moving average line on the chart. In its simplest form, if the price line is above the moving average, we are bullish, if it is below we are bearish. In chart 1 below we can see the FTSE All-Share index plotted over 2 years. The blue line represents the simple 50 day moving average (the average price over the prior 50 days). From this we can see that over the last 2 years the market has had long periods of upward trending prices where the FTSE All-Share is above the blue line 50 day moving average. The concept of only buying shares when the market is trading above the blue line is really a little too crude to use as a trading tool; although it does give a good snapshot indication of the current trend.
Chart 1 – FSTE All Share Index over 2 Years
To analyse what is happening in the market for trading today, we will look at the shorter-term trend. To do this we will use a 10 day moving average (green line), equivalent to two weeks of data. The smoothing effect of the average helps to eliminate short term fluctuations in the price so that the trend can be seen with greater clarity.
In chart 2 below, we can see that the FTSE 100 index is currently in a bearish phase in the short term because the is price below the average as therefore suggests a bearish phase. Using this technique with just one moving average is too simplistic as often the market will reverse back to the upside after dipping below moving average (green) line and by the time the price is trading above the 10 day moving average, the move may be over. It will often be too late to trade using this information and that is the real problem with this form of single moving average line analysis.
Chart 2 - FTSE 100 over 6 Months
Chart 3 Below incorporates one additional moving average, the 20 day more moving average in red. Now we have a full compliment of averages and we can immediately see that the market is trading below both the 10 and 20 day moving average. Does this mean the market can be interpreted as bearish? Not necessarily. The market will have strong upward trending periods where some fast corrections can be viewed as the healthy development of the trend. It gives the chance to buyers to get into the trend and take long positions.
The cross over of these 2 lines green and red can be used to give a better smoothed snapshot indicator of where the current trend is. A crossover of these lines often indicates a change in the trend.
The fact that we have not had a cross over of the red and blue lines (10 and 20 day moving average) in Chart 3 and in addition we are also trading above the 50 period moving average (which is bullish in significance), tells us to read this as a short term correction within a longer term uptrend. Common phrases such as “the trend is your friend” and “trade with the trend” can be applied to the results of the technique here.
The triple top gives more concern on the FTSE 100 chart and a confirmed breakout of the triple top will be an excellent bullish signal for a resumption into the uptrend.
Chart 3 – FSTE100 Index over 6 Months
Moving averages are lagging indicators, suggesting that they are better used to determine the trend and will often be too late in catching turning points. They work better when used in a strongly trending markets, whether up or down. They will be choppy when the market is trading sideways and this can be identified when the price line crosses over the moving average only to cross over to the other side in a short period of time. At this point in time, although there is a significant resistance level at 6754 in the FTSE 100 chart above, we are in still in an up trend in the intermediate (medium) term.
Rakesh Shah.
www.TenPointTrading.com
“Specialising in Trading Strategies” For more information on trading, visit our site.