By Jason Pearce
One of the first patterns that technical traders learn about is double tops and double bottoms. The belief is that history will repeat itself as a market peaks at a prior high or bottoms at a prior low. Supply/demand exhausted at these same points the last time around, so they’re likely to do so again. The idea is to get positioned for a major reversal from this level.
Additionally, a breakout above a prior high or break below a prior low indicates a major breach of support/resistance. Something has changed. The move should now be traded in the direction of the breakout as support/resistance has been conquered and the trend is expected to continue.
In the real world, however, these patterns are not usually as neat and clean as traders have read about in a trading book. Otherwise, every rookie trader out there would be a multi-millionaire in just a few short months.
Sometimes a market will bottom out and turn around before it tags the prior low of a move or peak out before returning to the prior top. That’s frustrating. The trader who was patiently waiting for the perfect setup will miss out on the reversal.
It gets even worse…
Markets will often surpass the prior high or break the prior low and signal a breakout. Then the traders looking for the double top/double bottom get stopped out. At the same time, other traders pile into the market on the breakout signal in anticipation of a continuation of the trend.
Murphy’s Law is then swiftly enforced as the market reverses shortly thereafter. Suddenly, it seems as if everyone loses on the trade attempt. So much for the idea of playing a zero sum game…
Bad News Is Good News
Chart patterns often fail. These failures often lead to sizable moves in the opposite direction. In particular, attempted breakouts above prior tops or below prior bottoms can lay the groundwork for some pretty big retracements that turn into trends.
Most importantly, the pattern failures can lead to tradable moves. This means that these initial pattern failures will often sow the seeds for new profit opportunities that follow immediately afterward. As traders, profit opportunities are exactly what we’re looking for!
While running a trade desk for over two decades, I have witnessed and participated in literally thousands of these failed breakouts. Waves of buy stop orders get triggered soon after the market clears a prior top and even bigger waves of sell stop orders get triggered shortly after the market turns back over. It didn’t matter if one was trading stocks, commodities, currencies, or bonds; this pattern was replicated across sectors.
We referred to this event as a Wash & Rinse pattern because the market seemed to knock everyone out of their positions before reversing.
Because the pattern failure initially racked up losses for both the bottom and top pickers and the trend followers, very few of the traders would get right back into the market to take advantage of the powerful move that started right after the reversal.
Most of the traders did not want to pull the trigger right after a losing trade because of Recency Bias. This was tragic because the move that followed the pattern failure ended up being the one that was the real money-maker.
Admittedly, the Wash & Rinse pattern is not my own unique observation. I’ve worked with other professional traders and even money managers who profited greatly from this pattern failure. They had other names for it (pivot reversal, specialists’ trap, the shakeout, etc.) but it was all the same thing.
The important thing here is that this pattern has worked, it does work, and it will continue to work. You can go back over several decades or price history and see this pattern in play on all sorts of markets. You can also look at some recent charts and see the same thing. The Wash & Rinse is a robust pattern and has longevity.
Despite the fact that many great traders have profited from this pattern, it doesn’t seem to get nearly as much attention as a classic double top or double bottom pattern. It doesn’t even get the same coverage as a breakout trade. But quality trumps quantity here.
The traders that do trade with this pattern seem to be the minority. They are members of the winner’s circle; the ones that profit consistently when the other participants are accumulating losses. I observed this phenomenon during my time at the trade desk. Once the failed breakouts above the prior highs (or breakouts under the prior lows) happened, the majority of traders did not go back in to trade the reversal…but a small group of the professional traders did.
Why It Works
The reason this Wash & Rinse pattern works is two-fold. First, traders who bought on the breakout get stopped out after the market returnd below the prior high. Some of the buyers were initiating positions and some were adding to positions they had already established on the way up.
The mass liquidations orders that hit right after the market broke back down below the prior high caused the sellers to overwhelm demand. As a result, the market sinks like a stone.
Secondly, the traders who were positioned on the short side in anticipation of a double top initially got their buy stops picked off on the breakout. Since they were already bearish, it’s a safe bet to say that most of them weren’t looking to immediately reverse course and start buying on the pullback right after the breakout failed. So we won’t see any demand for the market coming from this crowd, either.
Furthermore, if this second group of traders did decide to take another shot at the market, it was only to get short again. Adding that on top of the orders that are simultaneously coming in to liquidate the long positions and you have even more selling pressure put on the market. This can create a sustained move in the opposite direction of the initial breakout.
A Few Examples
Take a look at a few examples of the Wash & Rinse pattern in action. You’ll see that it works across all sorts of different markets. It doesn’t matter if you’re trading stocks, treasuries, currencies, or even commodities. This is the sort of robustness that a trader hopes for!
A few years back, precious metals and mining shares were running hot and the Gold Miners ETF (GDX) reached a record high of $64.62 in the last month of 2010.
After a pullback of a few weeks, GDX recovered and nearly returned to the 2010 high in April 2011. Alas, it peaked just shy of the 2010 high and rolled over again.
In September, however, mining shares were red-hot again and GDX broke out to new record territory.
The fourth week after the breakout, GDX had a meltdown as it went from a record price to a multi-week low. This Wash & Rinse sell signal was just the beginning of a multi-year bear market that knocked GDX off as much as 81% from the peak.
In the spring of 2012, things in Europe looked pretty bleak. So much so that the Spanish stock market (EWP) dropped below the 2009 Financial Crisis low of $24.33.
Spain’s market dropped nearly 19% below the 2009 low, but reversed sharply higher in the summer and closed back above it. This Wash & Rinse pattern marked the start of a two-year bull market that added 125% to the value of the Spain Index MSCI Ishares (EWP).
In November 2013, the nearest-futures coffee contract clipped the 2009 Financial Crisis low of 101.60. The market recovered before the week was over.
Little did anyone know that the Wash & Rinse buy signal off the November 2013 bottom would precede a weather market that would cause coffee prices to more than double over the next five and a half months! Using the leverage of a futures contract could have made this the Trade of the Year.
In the summer of 2015, the Japanese yen (cash) undercut the 2007 low of .8059. Traders were waiting for the multi-year bear market to accelerate on this break.
Instead, the yen flip-flopped for several weeks and then resolved higher. This bullish Wash & Rinse pattern was actually one of the reasons that I became so bullish on the Japanese yen at the start of 2016. The 26% rise from the 2015 low into the summer of 2016 is a great example of just how powerful this pattern can be.
Netflix (NFLX) posted a record high of $129.29 in the summer of 2015 and then took a breather for several weeks.
In early December, NFLX blasted to new record highs again. But the very next week, it went from a record high to a three-week low by the end of the week. This Wash & Rinse sell signal was the start of a vicious two-month, 40% correction.
Remember the 2014-2015 bear market that killed the oil industry? Well, it ended with a nice Wash & Rinse pattern that signaled loud and clear for traders to get long again.
The nearest-futures crude oil contract established a bear market low at $33.20 in January 2009. This price was undercut in January 2016 and a final bear market low was put in place five weeks later at $26.05.
Crude oil closed back above the 2009 low by late February 2016 -triggering Wash & Rinse buy signals on daily, weekly and monthly charts- and black gold prices nearly doubled from the lows by June.
Apple (AAPL) experienced a spike low in the summer of 2015 that marked its low for the year at $92.00. The stock neared this price again in January of 2016, but reversed higher before the low was breached.
Finally, support cracked in May 2016 when AAPL plunged to a nearly two-year low of $89.47.
The break didn’t last long, though. AAPL turned around the very next week and began an advance that is still under way today as the stock is trading at record highs.
Cerner Corp (CERN) is an interesting case, as it experienced a failed Wash & Rinse pattern, followed quickly by a successful Wash & Rinse pattern.
The March 2016 multi-month low of $49.59 was the first line in the sand for CERN. The stock breached this support level in early November and then bounced above it two weeks later. A Wash & Rinse buy signal was triggered.
The very next week, CERN dropped to a new correction low and negated the initial buy pattern. It also ended the week below the 2014 low of $48.39. Two weeks after that, the stock blasted higher and closed back above the 2014 low. This was the second Wash & Rinse buy signal.
After the buy signal, CERN backed down again. But this time it did not make a new correction low. It merely bided its time in a trading range for several days as the end of 2016 trading was wrapped up.
After the new year began the stock really took off and rewarded anyone who got long. So far, CERN has rallied over 27% from the December low.
Terrific Trades for Treasuries
Now let’s shift gears and look at a widely-followed Treasury ETF: The Ishares 20-Year Bond (TLT). This ETF is notorious for failed breakout attempts beyond prior highs and lows.
But that’s good news for traders looking to capitalize on the Wash & Rinse pattern! Opportunities abound on both the long side and the short side of this market.
2011 – TLT surpassed the 2008 top of $123.15 in late September/early October. The market never did make a weekly close above this price. Instead, it turned over and dropped a little more than fifteen points over a three-week period. TLT finally bounced and then settled into a multi-month trading range.
2012 – At the end of May, TLT finally gapped up and cleared the October 2011 top at $125.03. On week later, this ETF pulled back and spent nearly a month trading either side of the 2011 high. Had a trader gone short on this pullback and Wash & Rinse sell signal, he would have likely been stopped out when TLT raced back up to a new high in the second half of June.
A new Wash & Rinse pattern setup materialized. You see, TLT posted a high of $130.38 on June 1st and then pulled back. On July 23rd, the ETF closed above the June 1st high and stayed above for four days. But on July 27th, TLT dropped back under the June top and stated to decline in earnest.
By mid-September, TLT had dropped over fourteen full points from the July top. As a matter of fact, the bear market decline carried on for nearly a year and a half and dropped thirty-one points from high.
2013/2014 – In August of 2013, TLT posted a two-year low of $102.11 and bounced. The bounce eventually faded and this ETF traded to a new low of $101.17 on New Year’s Eve.
TLT blasted higher the very next week and started a thirteen-month run that boosted the price of the ETF by over thirty-seven points.
2015 – Soon after the New Year started, TLT surpassed the 2012 record high of $132.22. One week after the initial breakout, TLT pulled back to the 2012 high and immediately bounced. This solidified the breakout.
After posting a new record high of $138.50 on January 30th, the ETF started to weaken. One week later, TLT closed back under the 2012 top. Ultimately, TLT declined roughly twenty-three and a half points in about five months.
2016 – In late June, TLT gapped higher and surpassed the 2015 high. It peaked out at a new record price of $143.62 on July 8th and then sunk for a week. The market then went into a tight trading range until just after Labor Day. Interestingly, the bottom of the trading range was either side of the 2015 high.
TLT finally left the trading range on September 9th, but a bounce into late September soon followed. Coincidentally, the bounced ended right around the same level as the 2015 high point!
TLT rolled over at the end of September and started another descent that finally bottomed out in mid-December at 116.80. At this price, TLT had dropped nearly twenty-seven points in a five month period.
Worth a Look
At first glance, the new trader may be discouraged by the fact that double tops and double bottoms don’t appear as frequently or as perfectly as they were led to believe. Worse yet, the breakout trades often fail as well. But don’t throw the baby out with the bathwater.
As you saw in this post, the classic pattern “failures” can actually be one of your best opportunities for profit. I know professional traders who rely on this pattern and use it as one of their main trading tools.
In the next post, we will further discuss the Wash & Rinse pattern and how you can make it yours. In addition, we will also take a look at some markets that are currently setting up for potential reversal trades. You don’t want to miss this!
More Articles by Jason Pearce:
It’s easy to get caught up in the daily grind of price action and market sentiment. Sometimes it’s good to take a step back and look at the week in review to bolster your conviction for the week ahead.
- Weekly gasoline build – an anomaly or a sign of a trend?
- Increase in overall inventories since the export ban was lifted is tracking with the growth of US working storage capacity keeping contango at bay.
- Spreads between crude grades globally that have been supportive of US exports are narrowing (keep an eye on the WTI/Dubai spread)
- Front-month gasoline cracks held relatively stable given the bearish interpretation of this week’s gas build.
Weekly Oil Inventories post a net DRAW of 1.5 for the week ending April 14, 2017; Gasoline build the outlier (Figure 1):
However, given the move lower in prices, let’s take a closer look at the past Two week stock changes. Below you can see that total inventories have declined by 9.5 (thousand bbls/day) this year, yet we saw builds in inventories those same 2 weeks in 2016 and 2015.
The sticking point for the market is clearly the build this week in gasoline. Looking at absolute gasoline inventory levels below, I don’t believe this weeks’ data point ALONE is enough to solidify a trend of oversupply this early in the summer season.
Another way to keep storage levels in perspective is to look at the growth in storage capacity.
Figure 2 below highlights that the growth in total inventory levels is tracking slightly below the growth in working storage capacity (from the most recent EIA data through September, 2016). I understand that this is not a 1:1 comparison, however, it’s still relevant to the narrative. Growing capacity tends to reduce overall price volatility (as long as that capacity is used), but for short-term disruptions in the system. Risks to going long here hinge on whether a real trend is developing in gasoline withdrawals and the upcoming OPEC meeting.
The lifting of the export ban at the end of 2015 brought with it a tank storage boom. The market seized the opportunity to build pipeline, storage and dock logistics to capture favorable arbitrage economics and keep the export flow going. The most significant build-out of crude oil offloading and storage facilities has been along the Gulf Coast. Then in January, 2017 OPEC cut production of mostly heavy crude oil which opened up the arbitrage opportunities for exports. Going forward, crude oil production levels, the relative price of crude oil in North America to other markets, the market price structure and the cost of transportation will determine whether exports will continue to grow and if even more infrastructure is needed.
A key consideration in the build-out was the need to address the mismatch between the light sweet quality of most of the new crude now being delivered to the Gulf Coast from areas like the Bakken, and the heavier crudes that many refineries are configured to process. The Gulf Coast system has continued to add capacity in anticipation of increased throughput. See discussion in the next section regarding WTI’s discount to Dubai and other Middle Eastern heavier crudes which makes WTI more attractive for Asia.
Futures prices across the Petroleum complex fall roughly 4.75% week/ week in response to Inventory report:
Figure 3 below details the price declines of the key benchmark crude oils and spreads. Overall, calendar spreads moved in a bearish direction along with the outright price declines.
That being said, the June/Dec contango for US crude grades widened by less than $0.20 while the same spread for benchmark European and Asian crudes widened by more than $0.40. Spreads across crude grades were largely unchanged with a slight narrowing of the WTI/Brent and LLS/Brent spreads by a marginal $0.17 for the balance of the year. The narrower these spreads, the more economically enticing it is for US refiners to import foreign grades. In general, crude spreads have been tight enough this year that logistical ‘arbs’ (moving oil from one market to another) require a lot of creativity. The WTI/Dubai spread is the one to watch. When WTI trades at a discount to Dubai, the US export ‘arb’ to Asia is open. WTI’s discount to Dubai narrowed by roughly $0.15 yesterday for the balance of 2017 to around ($0.80). Looking out into 2018 however, the WTI discount to Dubai narrows to around ($0.25).
Except for the initial market adjustments to the Light/Heavy crude spreads due to OPEC cuts there aren’t many overall price differences to pull crude significantly from one market to another (absent specific refinery requirements). Will this be the impetus that slowly backs up crude inventories in specific regional markets? The US Net Import number will be key to watch.
Speaking of Net Imports, Figure 4 below shows a high-level comparison of total supply, net imports and futures prices for the last 3 years. Clearly, the reduction in Net Imports has been a key balancing factor.
Product prices decline slightly less crude, dropping just over 4% for the week (Figure 5 below).
**One thing to keep in mind when looking at settlement prices is the fact that different market closing times across the globe lead to a mismatch of settlement prices. This is evident in Gasoil prices in Figure 5. European oil markets settle at 11:30 EST. Meaning large afternoon price swings in the US aren’t reflected well in spread settlements.
While the product markets seemed to key off of an unexpected build in gasoline inventories, the decline in front month gasoline cracks was relatively muted as was the front month (June/Dec) backwardation. In general, this would favor pulling barrels OUT of storage, not building. Typically, if the Market is fearful of excess inventory levels such as gasoline, there would be big moves lower in cracks to discourage production. Instead, the entire complex moved lower in unison without much change in spreads. We shall see.
Week Ahead – Expectations and Wild Cards:
As noted above, the key items to watch in the upcoming week are:
- Signs that this week’s gasoline build was a trend or an anomaly. Look for front month gasoline cracks or backwardation to collapse further to indicate a trend vs. anomaly.
- WTI/Dubai Spread movements that would be problematic for US exports.
- Increases in storage capacity seem to be accommodating current production and inventory levels without widening the contango in the front of the curve.
There is nothing wrong with pre-positioning based on the expectation that the above conditions will change. Just make sure you know what you’re looking for!
Self-knowledge is the most important thing in trading. If you don’t know who you are, then any strategy will look good to you. And that is perilous for most traders, especially new traders.
What is most important is the proper trader mindset.
The stream that we used for this StockTwits AMA was #tradingtactics.Continue Reading...
By Jason Pearce
In a prior post on the subject of moving averages, we talked about what they are, the benefits of trading with them, and some of the common techniques that traders use. They are a simple, yet effective, tool for traders that have stood the test of time.
However, this does not mean that moving averages are going to be the Holy Grail of trading. While moving averages can be highly-effective, so much so that they may even start to take on a reputation of infallibility during those times when the markets are trending, they quickly lose their luster once the trend ends and the inevitable choppy period returns. When that happens, the profits accumulated while riding the trend can be quickly burned up.
When the trend starts eroding and moving averages start spewing out false signals, a trader has to concentrate on playing really good defense. That’s done by making sure you employ sound risk management, rely on diversification (both in terms of trading systems and the instruments being traded), and in some cases making adjustments in the trading parameters.
The first two points are non-negotiable. You can’t be successful without them. It’s the last point that is the gray area. Adjusting parameters will work for some, but not for others. That means you’ll have to test it for yourself and see if it makes sense to you.
In this post, I’m going to share with you a very simple solution for adjusting trade parameters. This is an approach that has allowed me to move quickly and methodically to recalibrate after a false moving average trend reversal signal. In other words, if I get knocked off the horse and it’s still running, I’ve got a way to get right back in the saddle.
Turn On the Radio
A useful analogy for this method is that the market is like a radio station and a moving average is your dial to tune it in. The failed signals that occur when you’re using a moving average are like static; you sometimes need to adjust the dial when this starts to happen.
Suppose a market is trending higher and experiences the normal pullbacks along the way. If the uptrend is still valid, the pullbacks should all be contained by a moving average that is trending higher with the market. There’s no need to adjust the dial because Dr. Johnny Fever’s voice at WKRP in Cincinnati is still coming through loud and clear on your radio.
Eventually, though, the market will experience a pullback that corrects far enough to finally break the moving average. Something has changed and this break is a sell signal. The trader will now liquidate long positions and maybe even go short because it indicates that the trend has changed.
So what happens if the market recovers after the correction and goes on to score new highs for the move? Well, one certainly can’t argue with the market and expect to win. The only logical conclusion is that the recent break of the moving average was a false signal.
Something has still changed, though. The failed moving average signal tells us that the countertrend volatility in the trend has changed, but the direction of the trend has not changed. Therefore, you either need to be long again or at least flat. There’s no justifiable reason for a trend follower to have any short positions on at this point. Unlike a DJ on the radio, the market does not take requests.
When this sort of failed moving average signal happens and tells us that the countertrend volatility has changed, a trader has two choices: she can take the next signal on the very same moving average or else she can try a different moving average in order to adapt to the new volatility.
Despite a failed signal, there’s certainly nothing wrong with using the exact same moving average for the next signal…and the one after that…and the one after that. This is what a 100% systematic trader does.
Many professionals would advocate this systematic route as the market will eventually break the same moving average and not recover. Then you’ll finally have the real trend change you were looking for. It’s just a matter of how many failed signals you might get first before a successful signal finally materializes.
Nothing is certain in trading, except for this: you will have a string of failed signals from any and all trading systems, whether or not it’s based on moving averages. Hence, the reason for proper money management and diversification. Drawdowns are a fact of trading and you don’t want to risk depleting all of your capital during the whipsaw periods.
After a failed moving average signal, there is another option: you can use a different moving average to trigger the next trade signal.
Let me warn you right now that if you opt for the second choice, you could potentially be crossing a line over into discretionary trading territory and getting out of the purely systematic one. However, just because you are acting like a discretionary trader doesn’t mean that you can just fly by the seat of your pants and that you don’t need any trading principles to guide you. In my experience, the successful discretionary trader usually has just as many trading rules and principles to guide them as a systematic one does.
Moving the Dial
Whenever I take the second route and decide to use a different moving average after a signal failure, I immediately look for a slower moving average –meaning a longer moving average- that was not violated during the market break. That might mean switching from a 20-day moving average to a 30-day moving average or from a 30-day moving average to a 50-day moving average.
The objective here is to get rid of the recent “radio static” by locating a smoother moving average that has not yet failed during the market’s trend. This is done in order to accommodate the markets change in the countertrend volatility that occurred when larger corrective moves started to happen.
This begs the question: why not use this slower moving average to begin with?
The reason is because a slower moving average lags further behind the market. This means that it will generate sell signals further away from the market tops and buy signals further away from the market bottoms. And we all know that every trader endeavors to sell as close as possible to the top and buy as close as possible to the bottom.
Dealing with Trouble
If a trending market is making very shallow pullbacks, the trend is being contained by a faster moving average. No problems here. It makes perfect sense to use this faster moving average that is running close to the market’s current price.
It’s when those pullbacks start to become sizable that the trouble begins.
The faster moving average will start getting picked off left and right with one false break after another, causing a string of losses, only to see the market turn right back around and continue the trend.
In an attempt to avoid racking up even more false signals and a continued losing streak, a slower moving average can be used. But the slower moving average is further away from the market’s current price, so you will most likely be selling at a lower price and buying at a higher price than you would with the faster moving average.
The trade-off here is one of speed vs. accuracy.
The faster moving average gets you in and out quicker, but generates more false signals. The slower moving average generates less false signals, but it gets you in and out of the market much later in the game.
What we are attempting to accomplish here with the use of parameter adjustments is to have the best of both worlds by using a faster moving average when it works and then switching over to a slower moving average when the fast one start to experience turbulence.
This certainly does not mean that the slower moving average won’t eventually fail at some point own the road. It will. It just means that, thus far, its track record for the recent trend has not yet been blemished. So the trader who switches to a slower moving average for the next trade signal will be risking capital on a parameter that has not yet experienced a loss during the current run.
Who Wants Pizza?
Let’s take a look at an example of how a trader might have used this method of “tuning in the radio” to trade Domino’s Pizza (DPZ) stock since last spring.
To keep things simple, the trades will be on the long side only. No shorting! Also, we won’t worry about the impact of commissions, slippage, position-sizing, etc. End-of-day prices will be used to determine the hypothetical profits and losses for each trade.
Initially, the 20-day moving average will be our weapon of choice. A two-day close above the 20-day MA is a buy signal and a two-day close below the 20-day MA is a liquidation (sell) signal. For this example, trading will commence on May 1, 2016.
After gapping down to multi-month lows in late April of last year, DPZ finally bottomed out at $116.91 on May 4, 2016. Three weeks later, the stock made a two-day close above the 20-day MA for the first time in over a month and triggered a buy signal at $121.29 on May 25th. Time to place our online order and buy some pizza stock. You want that with pepperoni and sausage?
On May 31st, Domino’s closed back under the 20-day MA. The next day it manages to hang on by the skin of its teeth and close back above the 20-day MA by a mere two cents. The long position stays intact. Boy, was that a close call.
On June 27th, Domino’s completes a two-day close below the 20-day MA and triggers a sell signal at $122.08. The result of this first trade is a profit of 79 cents-per-share. Not much, but it beats a loss or a poke in the eye with a sharp stick.
Just three days later, DPZ triggers a new buy signal when it gaps up to a two-month high and makes a two-day close above the 20-day MA. The entry price is $131.38.
The next sell signal finally comes on August 16th when Domino’s closes below the 20-day MA for two days in a row. The exit price of $143.97 results in a profit of $12.59-per-share. Now we’re cooking with gas!
However, a new buy signal is triggered just three days later at $147.28 and new highs for the move are reached one day after that. It’s a good thing we got back in.
But wait just a minute. Since the last two sell signals were quickly followed by new highs for the run, it appears that the 20-day MA is not doing all that great of a great job, after all. Although it’s getting us in the trade, it has bumped us out too early. We have to keep getting right back in the trade. That doesn’t even take into account the “near miss” we had on June 1st.
To move the dial and slow things down a little bit, let’s increase the moving average parameters by 50% and see how the 30-day moving average has been performing on this run.
As it turns out, a buy signal via the 30-day MA was triggered at $124.82 on June 7th. Although DPZ closed back under the 30-day MA on June 27th, it was a one-day event and not a two-day event like the 20-day MA experienced. Therefore, the trade would have stayed intact.
Furthermore, the stock stayed above the 30-day MA during the mid-August dip as well. So it would have been a winning trade for over two months now. Based on this, it makes sense to go ahead and make the adjustment and now use the 30-day MA for our new trade parameters after getting long again at $147.28.
On September 9th, DPZ dropped to a three-week low and close below the 30-day MA. Fortunately, it recovered the next day and a sell signal was avoided.
On October 5th, Domino’s had a three-day streak of dipping below the 30-day MA and then closing just pennies above it. Our luck finally ran out and a sell signal was triggered on October 14th when a two-day close below the 30-day MA prompted an exit at $151.12. This trade made a profit of $3.84-per-share.
Two days later, DPZ exploded higher and posted a new all-time high. I guess this proves that Domino’s really does have fast delivery!
This fast turnaround indicates that using an exit signal by way of the 30-day MA break was premature. Plus, it had some close calls back in early September and early October where some sell signals were narrowly missed.
To remedy this situation, we will slow things down even more with the moving average. To do so, we will increase the moving average parameters by about two-thirds and examine the performance of the 50-day moving average during this multi-month run higher.
Initially, DPZ made a two-day close above the 50-day MA on June 17th and triggered a buy at $127.79. It then made a two-day close below the 50-day MA and triggered an exit at $122.08 on June 27th. The trade resulted in a loss of $5.71-per-share.
The stock made a second two-day close above the 50-day MA on June 30th and triggered a buy at $131.38. Since then, DPZ has not once closed below the 50-day MA. The pullbacks in September and October -which both established the lows for the month- ended just above the 50-day MA.
This indicated that, after initially stumbling out of the gate, the 50-day MA has found it’s footing on the second trade attempt and is currently tuned in to the market. Therefore, after getting the new buy signal via the 30-day MA at $159.45 on October 18th, we will use the 50-day MA for any new trade signals going forward.
In mid-November, DPZ experienced a sizable three-day selloff that pushed it below the 50-day MA. However, the stock never went below the 50-day MA on a closing-basis. It recovered and went on to make new highs. Looks like we’ve made the right decision so far.
Domino’s sold off again in December. This time it did make a two-day close below the 50-day MA and triggered a sell signal. The trade was liquidated on December 13th at $161.86, resulting in a profit of $2.41-per-share.
Nearly a month later, DPZ finally makes a two-day close back above the 50-day MA and triggers a buy signal on January 11th at $168.96.
The question now is “Do we use a two-day close below the 50-day MA as our exit signal again or do we adjust the parameters again and see what an even slower moving average would do?”
If you look at the performance of the 75-day moving average (a 50% parameter increase from the 50-day MA) you will note that the two-day close below it on January 3rd was the first sell signal since the original buy signal was triggered at $132.59 back on July 1st. Also, the steep correction in mid-November ended after the stock tagged the 75-day MA and started to recover.
In addition, the 50-day MA and the 75-day MA aren’t all that far apart at the moment. Given the similar locations and the better recent accuracy of the 75-day MA, I would lean towards using the 75-day MA for new trade parameters.
Regardless of whether you pick the 50-day MA or the 75-day MA for your parameters on the new trade, the liquidation signal was triggered on April 10th at $173.75 when Domino’s made a two-day close below both the 50-day MA and the 75-day MA. This last trade booked a profit of $4.79-per-share.
The Results Are In
Recall that the trade campaign on Domino’s stock was initially started ten and a half months ago with the 20-day moving average. The objective of this strategy was to adapt to changes in the trend by finding and using the moving average that was not breached during the most recent countertrend moves. This means that it contained the corrections in the overall trend and didn’t get suckered by a “Larry Bird head fake” that shook out the faster moving averages.
Had a trader “remained static” and just stuck with using the 20-day MA parameters for entries and exits the entire time, he would have been in and out of the market eight different times. The results were four winning trades and four losing trades. Not taking into account the commissions and position-sizing scheme, the net result from trading DPZ would have been a profit of $17.02-per-share. That’s not too shabby.
However, the strategy of “tuning in the radio” would have only produced five trades. Yet they were all winners and the net result was a profit of $24.42-per-share (not including commissions, slippage, etc.)
As you can see, the parameter adjustment strategy had one-third less trades than using the 20-day MA alone. This would obviously have cut down on commissions and potential slippage. But even without taking that into account, the net profit of the parameter adjustment strategy was still a significant 43% greater than that of trading with the static parameters of the 20-day MA.
This one trade example does not mean that a parameter adjustment strategy will always make money or even that it will beat the results of a static parameter strategy every time. The point of the exercise was to get you thinking about the potential of having dynamic parameters that adjust to market conditions.
Even though it was mentioned earlier in the post that this sort of active management of the parameters was in the realm of discretionary trading, there’s no reason that it can’t fit neatly into the category of systematic trading. A trader would simply need to determine the rules for when to adjust the moving average parameters and what parameters to shift to. Once that’s programmed in, voilà, you have yourself a mechanical system!
Although the parameters for the trade signals are adjusted to progressively slower moving averages as the trend unfolds, I will still continue to track the faster moving average that I was originally using. The objective is to eventually put the faster moving averages back in the driver’s seat.
If the market makes another correction or two that is once again contained by a faster moving average, it means that the countertrend volatility is calming down. This allows a trader to keep “turning the radio dial” and adjusting the trade parameters back to the faster moving averages. Perhaps this means that will be switching from a 75-day moving average to a 50-day moving average to increase the response time. Then you might switch again from a 50-day moving average down to a 30-day or even 20-day moving average.
The end goal is to end up using the fastest moving average that is containing the trend without getting breached during the countertrend moves. You have to be vigilant to keep dialing it in and making adjustment as the market shifts until you find the best-fit moving averages for the current market trend.
Do Your Homework
The various moving average parameters (20-day, 30-day, 50-day, 75-day, etc.) that were used in this post are not set in stone. They are used to illustrate how the methodology works. Go ahead and test all sorts of different parameters, from ten days to fifty days to one hundred days or even more.
Also, investigate the different types of moving averages. Does a simple moving average meet your expectations? If not, you can explore using this technique with exponential moving averages, displaced moving averages, and other types.
In addition, you should research how this approach performs on different timeframes. Like any robust technical tool, this moving average parameter adjustment method works just as well on the weekly and monthly timeframes as it does on the daily and hourly charts. You need to find the right moving average parameters, the correct types of moving averages, and the timeframes that best accommodate your own style of trading.
One Factor of Many
Moving averages have been around for eons and have helped many a trader accumulate a fortune. They still work just as effectively today as they always have, even if the parameters have to be recalibrated from time to time. The moving averages can serve as the core entry/exit triggers for a trading system or they could be used for a confirmation tool or some sort of filter. There’s definitely some value to be found here by any trader.
It is important to remember, however, that the moving averages are just one of piece of the puzzle for successful trading. By no means should they be considered the Holy Grail in trading.
To trade successfully, you need to set up the correct position-sizing matrix. That’s created by good pyramiding rules and risk management. Moving averages only tell you when to get in or out of a market, not how many shares, contracts, etc. to buy or sell.
What you trade is an important factor as well. Choosing the markets that have historically worked well with your trading system certainly doesn’t guarantee future success. But why in the world would you ever want to have exposure in trading a market or instrument that has not worked well with your system or methodology before?!
When you have selected the moving averages that best fit your trading style…
And you have created your position-sizing plan…
And you have decided upon a portfolio of which markets to trade…
Then you still have to maintain the right mindset in order to follow your plan. Stay disciplined. Do not stray from the Path of Righteousness. If you can that, you’ve got a pretty good shot at trading success!
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