Section 2:

Objectively Identifying Trends III 

 

Double Moving Average Method

A solution to the slow nature of the Single Moving Average Method is combining two moving averages. This forms the Double Moving Average Method. It’s a technique that trend following traders have used for decades to objectively identify trends.

Either exponential or simple moving averages can be used in the Double Moving Average Method. In fact, a combination of the two could be used.

When considering which two moving average periods to use, start by picking from the table below. Consider picking a combination of short-term and intermediate term or intermediate-term and long-term:

5 day – 5 trading days in the week (short-term)
20 day – 20 trading days in the month (short-term)
50 day – Generally used by institutional traders (intermediate-term)
60 day – 60 trading days in the quarter (intermediate-term)
200 day – Generally used by institutional traders (long-term)
250 day – 250 trading days in the year (long-term)

The rules of the Double Moving Average Method are simple:

The trend is bullish if the shorter-term moving average is greater than the longer-term moving average.
The trend is bearish if the shorter-term moving average is less than the longer-term moving average.

Take another look at the FNM example from above, but through the lens of the Double Moving Average Method. Notice how the combination of the 5 day and 20 day simple moving averages helps to smooth out even this choppy example as shown in Figure 2.14 .

Figure 2.14

There are five changes in trend in as many months with the Double Moving Average Method. The trend changes are defined by the 5 day moving average crossing the 20 day moving average. The trend changes from bearish to bullish when the 5 day crosses above the 20 day moving average. The trend changes from bullish to bearish when the 5 day crosses below the 20 day moving average.

The Double Moving Average Method is exposed to the risks of volatility and whipsaws. But once a trend starts, the method stays quite consistent in identifying the trend. A good example of consistency is seen in Dry Ships (DRYS). The stock hesitated somewhat in the early stages of this example shown in Figure 2.15 , causing the 5 and 20 day moving averages to cross several times before eventually taking off.

Figure 2.15

Notice how the 5 day moving average stayed above the 20 day moving average as the stock moved from $60 all the way up to $130. But at the far right edge of the chart, the stock pulled back from $130 all the way down to $110. Yet the 5 day, at $119.22, was still above the 20 day, at $118.62.

The 5 day crossed below the 20 day a few days later, forecasting a much deeper pullback as shown in Figure 2.16 . Notice that the change from bullish to bearish trend wasn’t signaled until after the stock had already dropped by about $15 from its highs. But the stock ultimately went on to drop by about $55 from its high.

Figure 2.16

The Double Moving Average Method has its imperfections, but it also has advantages when compared to other methods. The combination of two moving averages helps to smooth volatile periods in stocks, which is perhaps the biggest benefit of the technique.

Double Moving Average Method Summary

Advantages:

Simple – An intuitive way of identifying trends.
Quick – Comparing two moving averages reveals the trend.
Consistent – Offers a very precise way of identifying trends.
Objective – It’s an either-or proposition almost all of the time.

Disadvantages:

Giveback – Stocks often retrace a large amount before the method signals a change in trend.

Objectively Identifying Trends Summary

No method of indentifying trends is perfect because the future is unknown. But the goal of trading is not perfection. The goal of trading is finding high probability situations that offer favorable risk and reward characteristics. The probability of success can be increased by following a consistent and objective method of identifying trends.

Each of the methods in this section has its unique advantages and disadvantages. The commonalities among all three are consistency and objectivity. We can’t stress enough the importance of being consistent and objective in every aspect of trading, starting with trend identification.

Trend identification is a vital step in trading price patterns. Price patterns, in fact, revolve around trends, either predicting the continuation of trends or the reversal of trends. With the problem of trend identification solved by using one of the three methods in this section, the next step is laying the foundation of price patterns. The next section focuses on the two building blocks of price patterns: support and resistance.