« The Four-headed Monster, Called 'Technical Analysis' (Part 3 of 4) »

[This is Part 3 of a 4-part series. Follow the links for | Part 1 | Part 2 | Part 3 | Part 4 |]

Moving Averages & Price Envelopes

A moving average is a price overlay that depicts the average value of a security, over a specific period of time. Moving averages can be of varying lengths and periodicities. One of the most common moving averages used by swing traders, is the 20-day Moving Average (’20-dMA’, for short). As you can imagine, the 20-dMA depicts the average price of a security, over the preceding 20 trading days.

Now, moving averages have several uses in their own right but perhaps the foremost use of the 20-dMA by avid technical analysts is in a ‘price envelope’ technique, known as the ‘Bollinger Bands’ technique.

Bollinger Bands are a graphical depiction of volatility and relative price level, over a given timeframe. This price envelope technique blends the statistical concept of standard deviation with the technical analysis concept of the price envelope. The Bollinger Bands are constructed by plotting an upper band two standard deviations above the 20-dMA and a lower band two standard deviations below the 20-dMA.

The usefulness of the Bollinger Bands technique is manifold. The trader studies the movement of the bands both in absolute terms and in relation to one another and comes up with an interpretation of the current market action, based on Bollinger Band theory.

Illustration 4 depicts the price action in this case study (plus the action that followed over the ensuing two weeks), overlaid with the 20-dMA and the Bollinger Bands.

Illustration 4: S&P-500 Index (SPX), as of Sep 15, 2010, highlighting 20-dMA and Bollinger Bands.

Now, while the 20-dMA and Bollinger Bands provided several buy, sell, buy confirmation and sell confirmation signals, over the course of the action seen on the chart (in the interest of time and space, we won’t delve into each of these signals, but notice that the mid-June and early-August peaks were formed when the index found resistance from the upper Bollinger band, which was flat in each of those instances), it must be mentioned that the 20-dMA and the Bollinger Bands were not necessarily calling for a bullish reversal at the end of August.

You’ll notice that each of the Bollinger bands and the 20-dMA were falling at the end of August, at a time when SPX was testing support at 1045. As such, these techniques were not necessarily challenging the contention that support was going to be broken, in the manner that the momentum indicators were.

On first blush, it might seem like this development is a contradiction of the bullish case; in fact, it is not unequivocally so. By their nature, moving averages and price envelopes generally tend to lag price action by a short span of time and, as such, they are often useful as sources of confirmation of a reversal that has taken place on the markets, instead of as predictors of an impending reversal.

On the first trading day of September, SPX found support at 1045 and sprung to 1080 in one leap. The index was sitting precisely at its 20-dMA, at the end of that session. The next day, the index broke through its 20-dMA. Such a move is considered a bullish confirmation signal. It provided those traders who had taken bullish positions when SPX was trading at 1045, a sense of confirmation that they had made the right choice.

Additionally, note that the lower Bollinger Band started to curve inwards, at the same time. This was another sign that the downtrend (on the minor level of trend) was over and, given that the 20-dMA had been broken, perhaps a move to the upper Bollinger Band was on the cards. If you look at the action that followed, prices did in fact end up rallying to the upper Bollinger Band, merely a week or so later…

The Importance Of A Holistic Approach To Technical Analysis

In the case study presented to you herein, we’ve shown you how technical analysis consists of a series of building blocks. Without each of these building blocks, the foundation of any chart reading exercise would be weak and the results of any trading strategy built upon this foundation would be potentially disastrous.

In fact, in this author’s opinion, it is precisely because dabblers in technical analysis draw conclusions from only a portion of the entire picture – and end up consequently deriving sub-par trading results therefrom – that the art of technical analysis has a bad rap in certain circles.

As an experienced researcher in the field of technical analysis, this author, who by the way has completed the equivalent of two graduate degrees in finance (most of which dealt with ‘fundamental analysis,’ which is the antithesis of technical analysis), can attest to the fact that there is no more effective set of tools for the short-, medium- or long-term trader, than the body of technical analysis.

When used properly, this set of tools is indispensable to the trader, because it allows him/her to remove emotion from the equation and provide him/her with the skills needed to identify potentially attractive trading opportunities for entry into, those that help identify when a profitable setup has run its course and needs to be exited from, as well as those that help identify when a setup has failed to live up to expectations and should be let go of.

As a seasoned trader who uses a “Purely Technical” approach, I’ll be the first to admit that technical analysis is not 100% foolproof. There is no trading approach that will produce a winning trade every time. But, when conventional technical analysis is used properly, with no shortcuts and with adherence to the rules, a trader’s rate of success can increase dramatically.

As such, a thorough grounding in technical analysis is a must-have, for every trader worth his salt…

[This was Part 3 of a 4-part series. Follow the links for | Part 1 | Part 2 | Part 3 | Part 4 |]

Sign up today to gain immediate access to our well thought out Stock Picks, Options Picks, Model Portfolio and Market Commentary.

Comments

[stock tips]

It was a awe-inspiring post and it has a significant meaning and thanks for sharing the information.Would love to read your next post too......
Thanks
Regards