By Jason Pearce

The Greenback In the Red

There is some compelling evidence that suggests that the multi-year bull market in the US dollar has come to an end.  Monetary policy, cyclical and seasonal patterns, and the technical outlook all make a good case of further weakness ahead.

If the US dollar does continue its descent, the first order of business for traders is pretty straightforward: you should be short the US dollar and long some of the other currencies.  That’s a “no-brainer” right there.

Now if you do not fancy yourself as a currency trader per se, don’t dismiss this conversation just yet.  You’re other investments may still be greatly affected by the trend in the US dollar.  Even if you’ve stuffed all of your cash under a mattress or converted everything to gold instead of holding one of those pesky fiat currencies, the trend in the value of that dollar still has an impact on your wealth.  It will determine whether you are gaining or losing purchasing power.  Being unaware of the trend in the greenback is irresponsible and staying unaware is downright foolish.

You should also pay particularly close attention to the trend in the greenback if you trade/invest in commodities and raw materials.  The effect of the US dollar’s trend is probably most noticeable here.  A rising US dollar means that US goods are more expensive to the rest of the world, so demand softens.  Price follows.  Conversely, a declining US dollar means that US goods are becoming cheaper to the rest of the world, so demand and price will rise.  This isn’t always the rule, but it stands true the majority of the time.

Interest Rate Effect

Interest rates are a major driving fundamental factor for currency trends.  In broad strokes, currencies trends are expected to move in tandem with interest rate trends.  If rates are rising, the currency should rise.  Conversely, if rates are declining, the currency should head lower.  This is Economics 101.

On the surface, the correlation between rates and currencies makes sense.  After all, investors are yield chasers.  They want to own the currencies with the highest yield in order to get the biggest bang for their buck…or Euro…or yen, etc.

In real life, however, it’s not always quite that simple.  Currencies often have a tendency to lead the target by factoring in the trend in monetary policy.  It’s a good example of that old Wall Street saying, “Buy the rumor, sell the fact.”  This does not happen every single time, but it does seem to happen quite often.  Often enough to wonder why you ever bothered to take Economics 101.

The current trend for US interest rates is higher.  On December 14th, the Fed raised rates for the first time in a year.  They hiked again in mid-March and are expected to do so yet again in June.  As a matter of fact, there are many economists and Fed members who see a couple more hikes before the year is out.

During this current trend in monetary tightening, it appears that the news of higher rates is discounted.  The US dollar index peaked on January 3rd a penny and a half higher than what the day’s high was when the Fed first hiked rates in mid-December.

When the Fed hiked again on March 15th, the greenback actually dropped about a penny and a half.  It has made a series of lower lows and lower highs since then.

If this current behavior pattern persists, the dollar could experience even more weakness at the mid-June FOMC meeting.  This would simply confirm that the tightening cycle has been completely priced in.

Presidential Cycle

The US Presidential cycle shows that the US dollar index often surges after the election, despite who wins.  This rally finally runs out of gas just before the middle of the year after the election.

This year, it appears that the expected peak in the greenback came early.  On January 3rd the dollar crested at a multi-year high and has been working its way lower ever since.

The second half of the post-election year starts in just a few weeks.  This is where currency traders should be paying close attention.

According to the US Presidential cycle, the second half of the post-election year is an ominous time for the dollar as the roadmap points lower for the next two years.  Bounces are expected along the way, but if this cycle holds sway, they won’t last long.  Rallies should be viewed as temporary events and short sale opportunities.

Seasonal Pattern

Based on the greenback’s seasonal pattern, we’re just a month out from where a major decline could commence.  This dovetails perfectly with the projection of the US Presidential cycle.  If so, the next few weeks could present an ideal timeframe to watch for a short sale opportunity.

Before we talk about this seasonal outlook, though, it is important to keep in mind that the seasonal patterns and cyclical patterns do not tell the US dollar what it has to do in the future.  These patterns are a statistical measurement that tells us what the market has done in the past and provides a projection of the most probable outcome moving forward.  Still, it creates a well-worn path that, if used properly, a trader can use to get an edge.

When I say used properly, I mean combining it with price action and giving the current price action priority over the seasonal and cyclical patterns.  If the buck follows the same path in 2017, trade accordingly.  But if the buck deviates from the path, do not try to force it into complying with your wishes.  The market will quickly show you who the real master is.

Now, onto the seasonal pattern…

The US dollar index has a seasonal tendency to peak in the first half of March and then decline until early May.  The buck stuck to the script for this part of the year as the March high was posted on March 2nd and the dollar headed lower for the next two months.

From early May though the start of July the greenback has a seasonal tendency to rally sharply.  So far, that has not been the case in 2017.  The buck has bucked the pattern as it moved lower throughout the month of May and recently touched the lowest price since the Presidential election took place.  This right here is a prime example of why traders need to obey price over seasonal patterns.

The first week of July is supposed to mark an important seasonal top that is followed by an overall decline until late October.  Around Independence Day, we should expect fireworks in both the literal and the figurative sense.  Currency traders should monitor the US dollar index closely once the second half of 2017 is underway.

A perfect setup from here would be for the greenback to make a bear market rally in June and then roll over after the first week of July.  If the buck bounces over the next few weeks, watch to see if there’s a moving average or chart pattern that supports the rally.  Also, observe how it reacts to technical resistance on the way up.  If the rally starts to erode once July starts, it could be a good clue that the next downdraft in the dollar has begun.

What Say the Charts?

On the daily timeframe, a Death Cross occurred on May 26th when the 50-day Moving Average closed below the 200-day Moving Average.  This is a well-known sell signal.  The last time it occurred was fourteen months ago and the greenback dropped for several more weeks afterwards.

More important than this Moving Average crossover signal, though, is the obvious bearish price pattern unfolding right now.  The US dollar index posted a multi-year high of 103.82 on January 3rd and then dropped to a low of 99.23 on February 2nd.  A bounce to a lower high of 102.26 on March 2nd was followed by a decline to a lower low of 98.85 on March 27th.

Once the Groundhog’s Day low was broken, the greenback had officially established a lower low and a lower high.  This downward trend has been confirmed as additional lower bounce highs and lower corrective lows have followed.  Until this pattern is broken, consider the US dollar to be in a well-defined downtrend on the daily chart.

On the weekly timeframe, the US dollar cracked important trend line support at the end of April.  The trend line was drawn across the May 3, 2016 low of 91.91, which set the low for the year, and the June 23, 2016 correction low of 93.01 that was established in reaction to the Brexit vote.

The US dollar index tested this trend line in August and September and then recovered.  The trend line really proved its worth during the Presidential election when it made a knee-jerk reaction and collapsed to a one month low, tagged the uptrend line, and then exploded higher just hours later.  The trend line confirmed its credibility.

After undercutting the Groundhog’s Day low on March 27th and touching the weekly trend line again, the buck bounced.  This was not a surprise.

The surprise came a month later when the bounce faded and the greenback opened ‘gap down’ on April 24th.  The US dollar had all week to recover the trend line, but it never did.  It has been below the trend line since.

Interestingly, the brief bounce into the May 11th high took the greenback right up to the bottom of the trend line and it immediately shrank back from it.  This confirms a classic charting rule: Technical support, once it has been broken, becomes technical resistance.

On the monthly timeframe, there are three ways that a case can be made that the multi-year bull market in the US dollar index has suffered a severe blow, maybe even come to an end.

First, there’s the Wash & Rinse sell pattern that took place.  The greenback initially had a double top established between the March 2015 high of 100.39 and the December 2015 high of 100.51.  The buck ran through this top back in November and negated the bearish pattern.  Just a couple of months later, the greenback reversed from making a new multi-year high to closing back under the 2015 top.  This failed breakout has bearish implications.

The second negative on the monthly timeframe occurred at the same time that the Wash & Rinse sell pattern was established.  The Fibonacci .618 retracement of the entire decline from the July 2001 fifteen-year high of 121.02 to the March 2008 multi-decade low of 70.69 was located at 101.79.  This important technical resistance was surpassed in November.  But like a junkyard dog running at full speed without regard to the chain around its neck and the stake firmly in the ground, the buck abruptly stalled out just a couple of pennies higher and was quickly jerked back down.  It appears that the Fibonacci .618 boundary is working.

Finally, the greenback finished the month of May below the 12-month Moving Average of its closing price.  Now, this bearish trend change signal does not always work.  Nothing ever does.  But you can see that a majority of the time it has led to lower prices in the months ahead or at least a multi-month consolidation period.  It rarely pays to bet against this bearish trend change signal.

Different Shades of Grey

The US dollar index is an unequally-weighted basket of six different currencies.  The biggest weighting is toward the Euro currency, which makes up 57.6% of the index’s value.  The rest of the currencies that make up the index are the Japanese yen (13.6%), British pound (11.9%), Canadian dollar (9.1%), Swedish krona (4.2%), and Swiss franc (3.6%).

You can short the US dollar index, of course, but you can also get more specific and bet on the long side of one single currency against the greenback.  There are several to choose from, but I will mention just a few of your choices here.

Since it has the most weighting against the US dollar index, the Euro currency might be a good instrument of choice for dollar bears.  It will run the closest to being a mirror image of the US dollar index.  More importantly, it has significantly more liquidity than the US dollar index does.  In the futures markets, the Euro currently has open interest of just over 451,000 contracts and the US dollar index has open interest of just over 84,000 contracts.  The bullish Euro currency ETF (FXE) has volume of just over 1,150,000 and the bearish US dollar ETF (UDN) has volume of just over 21,000.  Liquidity matters!

Although it only accounts for 13.6% of the US dollar index weighting, the Japanese yen is another currency worth consideration.  It’s a little less correlated to the US dollar index than the Euro currency is, but it’s still highly liquid and traditionally a great currency for trend followers.  In January the yen signaled a bullish trend change via the 20-month Moving Average, which has an admirable track record, and has stayed close to it since.  If you aren’t long the yen yet, there’s still time to hop on board that train.

Earlier in the post, I mentioned that the US dollar’s trend has a strong inverse correlation to commodities.  This also extends to commodity dollars like the Canadian dollar, Australian dollar, and New Zealand dollar.  These are the currencies of commodity-producing countries and are strongly linked to commodity price trends.  Therefore, a decline in the US dollar could be the rising tide that finally lifts these currencies from their multi-year slump.

Choose Your Weapon

All of the currencies can be traded in forex, of course. If you already have a forex broker and a platform you’re happy with, great.  You already know what to do, so just keep on keepin’ on.  But many currencies can also be traded via futures contracts or ETFs as well.  Make sure you think it through before jumping in.

I’m a bit biased because I started my trading career in the futures markets.  That being said, one of the things that I really like about currency futures contracts is that it offers tons of leverage (much more than you really need), but with regulations that they can’t seem to bother with in forex.

I recall a time when I had a stop order filled in forex on a Swedish Krona.  The slippage on the fill was bad enough, but I was really livid when I found out that some of the other banks I talked to didn’t even show that the price went low enough to trigger my stop in the first place!  When I complained to the bank desk I was trading at, they said, “Hey, we’re doing you a favor by even taking an order for a $7 million dollar position in the first place.  You can’t expect to get the same kind of fills as our institutional traders.”  That was the last time that I traded currencies in forex.  At least in the futures market, I know the price range is the same for everybody.

If you’re a smaller trader or new to currency trading, I suggest you steer away from forex and futures contracts for now and look at the ETFs.  You don’t get the same amount of leverage, but hey, you don’t need to mess around with high leverage when you’re new to trading or operating with a small stake.  Your goal should be to focus on following your trading process and preserving capital.

Once you have a few years of trading experience under your belt and your trading capital has grown, then you can proceed to…

Focus on following your trading process and preserving capital!

Perhaps you’ve heard the Zen saying that goes, “Before Enlightenment chop wood, carry water. After enlightenment chop wood, carry water.”

Well, maybe we should have a trader’s saying that goes, “Before Experience follow trade rules, manage risk. After Experience follow trade rules, manage risk.”

You will find that the successful traders don’t use nearly that much leverage, either.  Also, the pros don’t focus on how much money they can make; they focus on how much money they can lose.  Their time and energy is spent on monitoring their trading systems and managing risk, not trying to figure out how to turn a $10k account into $10 million in twelve months of day trading.

It’s a good possibility that the multi-year run higher in the US dollar has finally ended.  It’s time for traders to get loaded for bear.  Make sure you’ve chosen the right weapon (forex, futures, ETFs, options, etc.), you have enough ammo (risk size determines how many shots you can take), and then exercise patience (wait for the right setup and a trade signal).  Remember: A good hunter doesn’t chase; he waits.

More Articles by Jason Pearce:

Equities: US Against the World

Profiting From Failure: The Wash & Rinse Trade, Part II

Profiting From Failure: The Wash & Rinse Trade, Part I

How to Trade with Moving Averages, Part II

How to Trade with Moving Averages, Part I

Market Returns Do Not Equal Investment Returns with Leveraged ETFs

Is The Canadian Housing Market Bad for Canadian Banks?

2017: The Death Year for Stocks

Potential Bond Market Reversal Ahead

 

By Jason Pearce

If You Can’t Beat ‘Em…

In the first post on Profiting From Failure, we discussed how one of the first classic charting patterns that traders learn about – double tops and double bottoms- often fail to materialize like the trading books and blogs tell us they will.  Markets often surpass prior highs and lows, picking off the stop orders of those playing for a reversal.  So much for the easy money that we were all promised…

Furthermore, I noted that the alternative to double tops and bottoms – the breakout move- can go awry as well.  Traders place stop orders to buy a breakout above a previous high or sell a breakdown below a prior low, only to see the market run out of gas soon after and reverse sharply.

It’s easy to take that sort of behavior personally.  Betting on a reversal off the highs/lows didn’t work and betting on a breakout from the highs/lows didn’t work either!  Damned if you do, damned if you don’t.  Can anyone actually win at this game?

It’s important to keep in mind that the markets don’t know who you are.  They’re like the waves in the ocean; they don’t care if you’re having the time of your life and spending all day out there surfing or if you’re getting battered by the waves and on the verge of drowning.  The waves will do what they’re gonna do.  It’s your response and interaction with the waves that will determine your personal outcome.  It’s the exact same thing in the markets.

The fact that these classic pattern failures occur often is good news for traders with the right perspective.  Instead of simply avoiding these patterns, a trader can potentially profit by trading off the failure of these patterns.

We have dubbed these classic chart pattern failures the Wash & Rinse pattern.  Quite simply, when a market surpasses a prior high or low, the trader looks to get positioned if and when the market reverses back in the other direction.  These reversals are often the start of a tradable trend reversal.  I showed you several examples of this pattern at work in the prior post.

All in the Details

Let’s say that you see a market clip a prior high or crack a prior low.  It then runs all the stop orders.  Then shortly after that, the market it starts to reverse.  You might just have yourself a real live Wash & Rinse pattern trade in the making.  It’s a trading opportunity!

Now comes the tricky part: Where do you get in the market when it reverses course?

There are multiple answers that can apply here.  A trader can use an intraday trade back under the old high to get short.  Or for additional confirmation, he might wait for a close back under the old high to get a bona-fide sell signal.

Perhaps one would want to see a trade below the low of the bar where the breakout occurred before getting involved.  This would better negate the breakout and give you the greenlight to get short.

If you want to smooth things out a bit more, you can also apply these ideas to the weekly bar chart instead of the daily bar chart.  Your probabilities of success on the weekly timeframe might increase.  But the tradeoff is that waiting for the weekly bar signal might get you in later and at a much worse price than the daily bar signal.

Here’s one more idea to explore: Set a price band around the old high that the market is pivoting off of and wait for the market to trade back under price band (above the price band if it’s a trade on the long side) before getting in.  The price band could be a derivative of the Average True Range (ATR) to account for the market’s volatility.

These are just a few ideas that a trader can use to initiate a trade off a Wash & Rinse pattern.  I’m sure there are plenty of other ways for you to throw your hat in the ring.  I urge you to roll up your sleeves and do some deeper research on your own.  Discover what sort of parameters and triggers work best for your own trading style.  Then you can make this trading pattern one of your own weapons of choice.

Charting the Futures

Since futures contracts are always expiring and being replaced by the next delivery contract, it presents a unique charting wrinkle that does not occur with stocks, ETFs, and cash currencies.

Most longer-term futures charts are created by splicing together the prices of the closest-delivery contracts and rolling them over based on either the expiration of the nearest contract or a change in leadership where the trading volume and/or open interest in the nearest delivery shifts to the next delivery contract.

Due to carry-charges, interest rates, seasonal pricings, price squeezes, etc. the futures prices can sometimes vary noticeably from one delivery contract to the next.  So the rollover on the long-term charts can potentially create a chart pattern –like a Wash & Rinse pattern– that does not necessarily occur on the specific delivery contract being traded.

From my experience, this has not really been an issue.  The pattern still holds up.

But for traders who are concerned that it may be problematic, a filter could be added to the Wash & Rinse pattern by making sure the price on the specific delivery contract that they are trading is in agreement with the Wash & Rinse pattern that they are seeing on the larger timeframe.  Something simple, like a trend line break, a moving average crossover, a breakout signal, etc. should do the job.

Failure of a Failure

Question: What should a trader do if a Wash & Rinse pattern fails and the market hits new highs for the move (or lows for the move in a downtrend)?

Answer: Get out!

It is important to keep in mind that this pattern does not work every time.  Nothing does.  Sometimes you win, sometimes you lose.  The trick is to minimize the damage when you lose and exploit the opportunity when you win.

As far as losing goes, you should immediately place protective stop orders as soon as you get into a trade position.  The protective stops are set to liquidate your position automatically if there’s a reversal.

Logically, a new high after initiating a short position or a new low after initiating a long position means you are wrong.  You need to abandon the trade ASAP.  Even the Top Gun pilots use the ejection seat when the situation calls for it.

But Wait, There’s More!

Here’s a bonus second answer to the above question: If you have the stomach for it, you can even get positioned back in the direction of the initial breakout.

The Wash & Rinse pattern is a pattern based off of a failure of another pattern.  Yet, there are times that this failure pattern will also fail!  Hey, nobody ever promised that trading is easy…

Sometimes a market will breakout, experience a pullback that knocks out the weak-handed players and triggers the Wash & Rinse pattern, and then turn right back around to continue on with the initial breakout move.

This means the Wash & Rinse pattern didn’t work.  It also means that the initial breakout, while initially sloppy, is still in effect.  There’s still plenty of demand for the market so the path of least resistance remains in the direction of the initial breakout.  If you are going to get back on this horse, you better be going in the same direction that it’s running.

As an added benefit of the second breakout attempt, the reaction low of the pullback that immediately precedes it creates an obvious line in the sand for strong near-term support.  Placing sell stop orders below this level provides you with a logical bailout point and defines your risk on the trade.

Current Market Setups

One you have a grasp on how the Wash & Rinse pattern works and you have worked out the details for your own entry and exit criteria, it’s time to take it for a test drive.

You can do this by ‘paper trading’ the markets as they unfold.  It’s important to keep honest records.  That’s the only way that you can make real progress.

Now, if you really want to shorten the learning curve and make the emotional connection that comes from having real money on the line, you can do trade these in real-time with small positions.

In the prior post, we showed several examples of how some Wash & Rinse trades played out.  Now we’ll take a look at a few markets that have recently staged a breakout or are getting close enough to prior highs/lows to warrant attention.  Put these on your watch list as they have the potential to turn into Wash & Rinse pattern trades.

In mid-February, the ETF for the Brazil Index (EWZ) closed above the 2016 high of $38.50.  The following week, it closed back below the 2016 high and a Wash & Rinse pattern went into effect.

After bouncing off the March low, EWZ tagged the 2016 high again.  It reversed sharply before the day was over.  This keeps the Wash & Rinse pattern in play.

Aflac (AFL) set a record high at $74.50 late last summer.  It was actually made by way of a Wash & Rinse sell signal off the daily chart high that was set six weeks prior.

This week, the stock surpassed the August 31, 2016 and posted a new record.  Initially, this is very bullish.  But keep a close eye on it.  A failed breakout attempt up here could pave the way for another short sale opportunity in AFL.

Back in February, Continental Building Products (CBPX) surpassed the 2016 high of $24.78.  The stock advanced for a few more weeks, indicating a legitimate breakout.

At the end of March, however, CBPX closed back under the 2016 top.  This negated the breakout and triggered a sell signal as per the Wash & Rinse pattern.  Since the stock is still just a stone’s throw from the 2016 pivot price, traders still have opportunity to get short.

Genesco (GCO) traded a little over two dollars away from the September 2016 multi-month low of $47.66.  This level marked the start of a three-month advance that boosted the stock by 51%.  Watch this stock carefully to see what transpires.

Moody’s Corp (MCO) topped at a record high of $113.87 in the summer of 2015 and then surrendered nearly one-third of its value over the following six and a half months.

The stock finally recovered and blasted to a new high just last week.  The fun continues this week with another gap higher.  But should it fail to continue its trek, you’ll have a Wash & Rinse sell signal in the works.

Revlon (REV) has been in a nosedive since the start of March.  It is fast approaching the January 2016 low of $24.20, which was the lowest traded price in nearly two years.

As you know by now, a drop below the 2016 low, followed by a reversal higher, would be a Wash & Rinse buy signal.

It appears that Regis Corp (RGS) is reaching a do-or-die level.  The stock is right on the doorstep of the September 2015 multi-year low of $10.60.  After that, the last stop is the 2008 Financial Crisis low of $8.21.

Although this stock currently looks like a dumpster fire you should stay away from, a Wash & Rinse pattern might still give you a technical reason to take a shot at the long side.  The last time it traded down here, a 71% rally followed in just nine weeks.

If you want to see a stock that has bucked the trend of the bull market, you need to look no further than Twitter (TWTR).  This one has been a complete train wreck.

As traders, though, we are not looking for a company to buy.  We are looking for a setup to pull some money out of the markets.

The record low for TWTR was set at $13.72 on May 24, 2016.  The stock dropped as low as $14.12 this week.  It’s getting close.

Don’t forget that TWTR rallied as much as 85% off the lows last year and it only took a little over three months.  Should the 2016 low get breached, followed by a reversal, a Wash & Rinse buy signal might be worth trading.

The recent drop in industrial metals has hit the stock prices of the producers pretty hard.  Olympic Steel (ZEUS) is one of those companies currently feeling the pain.

ZEUS bottomed out with the main market during the Presidential election.  The low of the correction was established at $17.14 on November 8th.

ZEUS recently cracked the November low and traded to a new one-year low.  The correction could continue, of course.  However, a reversal from here could create a Wash & Rinse buy signal.

The currency markets seem to be in limbo.  On the one hand, the late 2016 breakout to new multi-year highs in the US dollar index and new multi-year lows in the Euro currency stalled out and triggered Wash & Rinse pattern signals right after 2017 began.

On the other hand, there has not been any follow through on the reversal patterns.  The greenback and the Euro are just a stone’s throw from the multi-year levels that were posted during the first week of 2017.

Theoretically, the currencies could decide to stay range-bound at these multi-year levels for the rest of the year.  In reality, however, they are worth monitoring on the weekly and monthly timeframes to see which way things will resolve.

Changes in economic data trends, stock market corrections, Tweets from the Commander In Chief, further rate hikes and/or changes in the expectations of further rate hike expectations, etc. all have the potential to be catalysts for the next move in forex.  Currencies are currently a slow moving train, but they may be one worth boarding soon.

Speaking of rates, take a look at Ishares 20-Year Bond (TLT).  It triggered a small Wash & Rinse buy signal back in March when it undercut the December low of 116.80 and then immediately reversed higher.  This may have been the low of the year, so traders could consider buying pullbacks in TLT.

But…

If TLT breaks down again and breaches the current low of 116.49 it will negate the Wash & Rinse pattern.  It would be a blessing in disguise as it may allow the ETF a chance at testing the June 2015 low –which also marked the low for the year- at 114.88.  A Wash & Rinse buy signal off this low would certainly be worth taking a shot at.

Deutsche Bank offers an easy way to own a basket of agricultural markets via an ETF.  Of course, “easy” doesn’t always mean “profitable”.  Anyone holding the DB Agriculture Fund (DBA) as a long-term investment has racked up losses in five of the last six years.  The +2.6% gain in 2014 offered little consolation –and very little profit- to the Buy & Hold crowd.

From a trading perspective, however, a buying opportunity may be setting up.  DBA recently clipped the February 2016 record low of $19.55.  Depending on how it unfolds from here, a Wash & Rinse buy signal could potentially materialize.

Also in the commodity sector, the cocoa futures market looks really interesting right now.  The 2011 low on the nearest-futures chart was $1,898.  Cocoa clipped this low in February and immediately bounced, triggering a Wash & Rinse buy signal.

The bounce faded and cocoa dropped back under the 2011 low.  In addition, the market traded below the February low.  This constitutes as Wash & Rinse pattern failure.  It’s a sell signal.

However, cocoa has now cracked price support at the 2008 Financial Crisis low of $1,867.  A reversal higher could trigger yet another Wash & Rinse buy signal.   If you like chocolate, watch this one carefully!

More Articles by Jason Pearce:

How to Trade with Moving Averages, Part II

How to Trade with Moving Averages, Part I

Market Returns Do Not Equal Investment Returns with Leveraged ETFs

Is The Canadian Housing Market Bad for Canadian Banks?

2017: The Death Year for Stocks

Potential Bond Market Reversal Ahead

By Jason Pearce

Charting 101

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.

Widely-Know Secret

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.

However…

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:

How to Trade with Moving Averages, Part II

How to Trade with Moving Averages, Part I

Market Returns Do Not Equal Investment Returns with Leveraged ETFs

Is The Canadian Housing Market Bad for Canadian Banks?

2017: The Death Year for Stocks

Potential Bond Market Reversal Ahead

By Jason Pearce

Recap

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.

Your Options

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!

Keep Fine-Tuning

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!

More Articles by Jason Pearce:

How to Trade with Moving Averages, Part I

Market Returns Do Not Equal Investment Returns with Leveraged ETFs

Is The Canadian Housing Market Bad for Canadian Banks?

2017: The Death Year for Stocks

Potential Bond Market Reversal Ahead

By Jason Pearce

The Basics

A moving average is exactly what it sounds like: It’s the average market price of the last “X” number of time intervals, whether that’s hours, day, weeks, months, etc. and it’s called a moving average because the average price is updated every time there is a new time interval recorded.  Therefore, the data set moves to always stay with the most current data set.

For example, let’s say that the 20-Year Bond ETF (TLT) closed at $131.58, $130.57, $131.74, $130.62, and $130.09.

The average closing price of these five days is $130.92.

Then the next day, TLT plunges and closes at a price of $124.57.

So we would take the prices of the most recent five days and calculate the average price all over again.  Since we now have a new data point ($124.57), we simply drop the oldest data point in our series ($131.58) and recalculate.

The new five-day moving average of the closing price is $129.52.

It’s important to establish right up front that a moving average is a lagging indicator.  It tells you where the market has been; it does not tell you where the market is going.  This isn’t some mystical map to lead you into a magical forest full of money trees.  It’s not even a fool-proof market indicator.  Moving averages are simply a guide.

Where the moving averages do prove their worth is by helping a trader identify when a market is in a trend.  After all, finding a market trend and getting positioned on the right side of it is the first step to making money!

Up or Down

A market is considered to be in an uptrend when it’s above the moving average price and it’s considered to be in a downtrend when it’s below the moving average price.  In other words, you want to buy a market that is performing above average and sell a market that is closing below average.

You can also compare two different moving averages to determine when to buy and when to sell.  This is known as a moving average crossover.  When a faster (shorter-term) moving average closes above a slower (longer-term) moving average, it’s a buy signal.  When the faster (shorter-term) moving average closes below a slower (longer-term) moving average, it’s a sell signal.

This is pretty simple stuff, right?

The Path of Righteousness

Years ago, I had a mentor who used to tell me, “Follow the path of righteousness.”  No, he wasn’t my guru or spiritual mentor.  He was a trading mentor.  The Path of Righteousness that he was referring to was the market’s moving average.

This mantra was his very simple way of telling me to follow the trend and patiently stay in the trade as long as the market continued to close above the moving average that I was using.

Likewise, if the market finally cracked the moving average that had been supporting the move higher, it was my cue to exit the position stage right.  “Take the money and run” as the song says.  In some cases, the break of the moving average was even my prompt to reverse and get positioned on the short side of the market.

Perhaps trading a system with the moving averages is a bit like Zen after all.  It’s deceptively simple to understand, yet it takes continuous practice and self-discipline to keep at it.

Pick Your Weapon

There are several types of moving averages out there.  The one we already discussed is called a Simple Moving Average as it gives equal weight to all of the data points in the series.

Another popular type of moving average is an Exponential Moving Average.  This one puts more weight on the more recent data points, which causes it to react faster than the Simple Moving Average does.  The belief is that the more recent data points are more important than the older ones; hence, they should carry more influence.  This is why a lot of the professional traders favor the Exponential Moving Average over the Simple Moving Average.

If you wish, you can continue to go even further down the rabbit hole and research Weighted Moving Averages (where each piece of the data set is assigned different weights), Displaced Moving Averages (a moving average that is pushed forward in time in order to filter out potential whipsaws), Triangular Moving Averages (where the heaviest weighting is assigned to the midpoint of the data set), and some other complex formulas.  You can even create your own proprietary moving averages if you don’t see one that suits your fancy.

Also, you can choose to calculate the moving average of the market highs…or lows…or even the openings.  A trader could even get really cute by calculating some average of the day’s range and making a moving average out of that!

Those most common metric for the calculation is the moving average of the closing price.  This makes sense as it focuses on what I believe to be is the most important price of the day.  The reason for this is because the market’s final settlement is where the traders with the most conviction -and also the bankroll to hold it- are willing to go home with the position.  The day traders and the HFT algos are cashed out by the time the closing price is established.

Looks like things are getting a little less simple now…

Popular Metrics

In addition to the different types of moving averages, you also have to determine the length of the moving average that you’re going to use.  The proper length of moving average for you is directly correlated to the type of move you’re playing for.  Are you more of a hit & run day trader?  Or are you a trend follower who starts to look like a Buy & Hold investor when the trend is moving favorably?

If you are trading the fast, strong momentum moves, the short-term moving averages are where you should concentrate your efforts.  This is because a smaller data set, say five days instead of one hundred days, will change at a much faster rate.  This is exactly what the doctor ordered for someone who’s only looking to scalp a fraction of the move out of a market.

However, if you are surfing a macro trend and playing for the long haul, you’d want to use a long-term moving average.  Since a long-term moving average has a lot more data points, each new data point has a much smaller impact on the change in the average price than the short-term moving averages will.  By making it slower to change, it is less likely to generate less false signals during a market hiccup and shake you out of a position prematurely.

Some of the popular parameters for the short-term trading crowd are the 5-, 10-, and 13-day moving averages, while swing traders will slow it down a notch and go for the 20-day moving average.  One of the pioneers of trend following, Richard Donchian, used a combo with a moving average crossover system that relied on the 5-day MA and 20-day MA.

Medium-term traders tend to gravitate toward the 50-day moving average and the long-term guys normally follow the 200-day moving average.  As a matter of fact, Paul Tudor Jones said that his metric for everything (stocks, commodities, currencies, etc.) is the 200-day moving average.  He has a standing rule to get out of anything that falls below the 200-day moving average.

The 50-day MA and the 200-day MA can also be combined to be used as a widely-followed crossover system to identify long-term market trends.  When the 50-day MA crosses above the 200-day MA, it’s referred to as a Golden Cross.  Time to go long because the bull market is roaring!  Conversely, when the 50-day MA crosses below the 200-day MA, it’s referred to as a Death Cross.  This ominous-sounding signal indicates further downside ahead.

The Best Pick

Some guitar players looking to emulate their hero may know that Stevie Ray Vaughn used unbelievably thick guitar string gauges that start at .013.  So they slap a set of heavy gauge strings on their Strat and expect to start playing just like him.  However, Al Di Meola uses a more reasonable 10-gauge set.  On the other end of the spectrum, Chuck Berry and Jimmy Page both favored 8-gauges (think “banjo strings”) that allowed them to play almost effortlessly.

So what’s a player to do?

The answer is simple: you need to find the gauge that suits your own playing style the best.  It’s safe to say that the string gauge was not the defining factor of success for any of these guys.  But they did find the gauge that best suited their needs.

In the same way, traders have to do a little bit of research and testing to determine which moving average type best fits their own style and personality.  Your goal is to find the moving average parameters that make the most sense to you, not blindly follow the same one that your trading hero uses.  Like Polonius said in Hamlet, “To thine own self be true.”

Ultimately, if a market really is trending, all of these different types of moving averages should eventually generate similar buy and sell signals to get you on-board the move.  So it shouldn’t make too much of a difference which kind you are using.  There will be some variance, of course, such as one producing more false signals or one is getting in/out of the market earlier than another, but sooner or later they should all be participating in the same trend.

Moving Averages Work Great…

Except when they don’t.  Moving averages will only work their magic when the market in focus is trending.  Otherwise, they will get chopped to death.  A market with no trend will pop above the moving average for a few days, go back under it for a few days, jump back above if for a few more, etc.  A trader who keeps buying the closes above the moving average and selling the closes below the moving average in this type of environment could see their account bled dry…all while the market that is simply spinning its wheels and going nowhere.

Markets will cycle through both types of environments, trending and non-trending.  Therefore, no trading system works all the time.  To expect otherwise is unrealistic.

Unfortunately, markets tend to trade in choppy ranges a lot more than they make sustained trends.  Some statisticians say the markets only trend about one-third of the time.  Some say it’s even less.  That’s bad news if you’re a trend follower.  And if you’re trading with moving averages, regardless of the timeframe, a trend follower is exactly what you are.

There is some good news, though.  The markets don’t all have to trend together or get held hostage in a trading range at the same time.  When some of the markets are trending, others are choppy and vice versa.  With all the available investment vehicles we have nowadays, the candidates for a potential trade seem nearly unlimited.  Heck, you can even spread one market against another and create even more potential trading candidates!  Therefore, you can afford to be picky and ignore any market that’s not currently in an obvious trend.

Rule of Thumb

Here’s one simple, but effective, rule that a trader could implement to avoid getting suckered into some of the choppy trading environments: Don’t trade any market where the moving average has gone flat!

We’ve already established the fact that a moving average is a lagging indicator.  It’s useful to wait for these laggards to start moving north or south before committing to any trades.  At the very least, we will know that the move in the underlying market has been sustained long enough to start pulling the moving averages with it.  As we all learned in physics class 101, a body in motion tends to stay in motion.

If this lag is unacceptable to you because you’re looking to get in right at the bottom or sell out right at the top, then you are not interested in trend following, anyways.  You are looking for a leading indicator and something that has predictive power.  That’s fine.  Just don’t try to accomplish this with a lagging indicator like moving averages!

Using a tool improperly is hazardous to your wealth and sometimes even your health.  You need to learn how to use your tools safely and effectively like Bob Vila did on This Old House, not like Tim “the Tool Man” Taylor did on Home Improvement.

Adapt or Die

It is very important for traders to remember that the market price can never be wrong.  It is what it is.  The market is the dog and the trade indicators (moving averages, stochastics, MACD, etc.) are simply the tail.  The dog wags the tail, not the other way around.

So when a moving average starts giving failed signals, it could mean one of two things: either the market trend has finally come to an end or else the volatility of the trend has expanded.  Either way, something has changed.

Leon Megginson, a LSU professor of business management, said, “It is not the strongest of the species that survives, nor the most intelligent, but the one most responsive to change.”  This quote is perfectly fitting for a trader.  To survive the market’s behavior change, a trader must adapt to the new reality.  It can be accomplished by making trade parameter adjustments, relying on good risk management, using multiple non-correlated trading systems, practicing portfolio diversification, and any combination of all of these.

By the way, true diversification does not just mean that you are trading in several different markets, but that you are trading in non-correlated markets.  Having a position in the S&P 500, the NASDAQ, and the Russell 2000 is not very diversified, while having a position in copper, lean hogs, and some foreign currency (usually) is.

Coming Attractions

One thing that I have found success with in trading the moving averages is making parameter adjustments that adapt to changes in the market.  This allows me to recalibrate when a whipsaw or false reversal signal manifests during a trending market and throws everyone off the horse.

In an upcoming article, I will reveal my strategy for determining when and how to adjust the parameters to get back on the horse or, at the very least, continue to ride the bull or the bear.

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