Trending Indicators - 5 PDF

Advanced Technical
Analysis
Trending Indicators
“The trick is to differentiate between

what you want to happen and what
5
you know will happen.”
—Jack D. Schwager
Section 5 of 8
Advanced Technical Analysis
Introduction
KEY CONCEPTS
The adage “The trend is your friend” is mentally tattooed on
1. Trending indicators are most every successful trader’s mind—trading with the trend can greatly
effective during trending markets. increase their trading success ratio. Trending indicators can help
2. Using a trending indicator during a you take advantage of the market periods in which a prevailing
sideways or channeling market can trend is the driving force. Although the market trends only about
cause you to be whipsawed.
50 percent of the time, most of your profits will be made during
3. Moving averages, moving average these trends. Most trading losses tend to come when the market is
envelopes and Bollinger bands are
channeling sideways and whipping back and forth. (We will learn
trending indicators.
how to profit in these markets too using oscillating indicators in
4. Moving averages can be divided
Section 6).
into two groups: simple moving
averages and exponential moving
averages.
A trend is loosely defined as a period during which a stock is
consistently moving either up or down. The length and strength
5. Trading with more than one moving
average increases your odds of of the trend depends on the time frame you are analyzing—
success. whether it is a 1-minute chart or a 1-week chart. Most technicians
6. Moving average envelopes provide will also look for confirmation of the trend they see on shorter-
additional support and resistance term charts by checking the trend on longer-term charts. An
levels to a moving average. apparent uptrend on the daily charts can be confirmed by
7. Bollinger bands take volatility into examining the trend on the weekly charts. If the daily charts show
account when computing additional an uptrend while the weekly charts show a downtrend, a technical
support and resistance levels. trader knows the trade will carry more risk.
Trending Indicators
INVESTOR TIP
We will be using three tools to identify and trade with the trend:
moving averages, moving average envelopes and Bollinger bands.
Use trending indicators during trending
markets. Use oscillators during
channeling markets. Moving Averages
Moving averages are the most commonly used tool to identify a
trend. Moving averages smooth trend lines to avoid the “static”
of erratic price movements. There are several ways to calculate
a moving average. We will discuss two of them in this section:
simple moving averages and exponential moving averages.
Moving Average Envelopes

A moving average envelope creates a channel that parallels a
moving average. It allows traders to both identify the trend and
use the upper and lower boundaries as support and resistance
levels.
82 INVESTools Investor Education®

Section 5 Trending Indicators
Bollinger Bands
Bollinger bands are a modification of moving average envelopes.
But rather than surrounding the moving average by a constant
percentage, Bollinger bands use a measure of historical volatility
to adjust their bandwidth. This means the bands will narrow and
widen over time.
Trending indicators can be used alone or they can be used in

combination with oscillators and other technical indicators
such as candlesticks. Armed with these tools, you will be able to
identify the trend and various buy and sell signals more easily,
all of which will increase your probability of a successful trade.
Utilizing the three indicators discussed above, in this section we
will be discussing five trading methods: the single moving average, INVESTOR TIP
two moving averages, moving average envelopes, trend following and
the “squeeze.” Moving averages, as with any
indicator, will always lag the market
because they rely on past data.
Moving Averages
Moving averages draw information from past price movements to
calculate their present value. Moving averages are quite simple to
read and use, but because they rely on past data, they always lag
the market—an inherent weakness of any indicator that relies on
past data. This means moving averages only show trend changes
after the market has begun to decline or rise. Ultimately, one
danger of this lag is that trades signaled by the moving average
alone can whipsaw a trader by delaying both the entry and the
exit signals.
To mitigate the risk of being whipsawed, you should consider

combining moving averages with other technical indicators.
Entering a trade after a morning star candlestick formation
accompanied by a bullish moving average, for instance, increases
your odds of having a successful trade because you are trading
with the trend. Selling short when a bearish flag appears while
the moving average is trending downward will also improve your
chances of a good bearish trade. In most cases, the best way to
apply moving averages is to use them as trend indicators and
possible indicators of support and resistance levels.
© 2006 INVESTools Inc. All rights reserved. 83

Figure 5.1—Simple Moving Average on XOM
Simple Moving Averages

A simple moving average is calculated each day by averaging the
closing prices over a specified period of time. For example, if you
want to apply a 20-day simple moving average to a stock, you
would take the closing prices for the last 20 periods, including
today, add them together and divide the sum by 20 (the number
of periods you are analyzing). This produces the arithmetic mean
of the past 20 days’ closing prices, which is then plotted on the
chart.
You can see how a simple 20-day moving average smooths out
the choppy price movement on the Exxon Mobil (XOM) chart
shown in Figure 5.1. When you trade with the trend, the odds
of the trade moving the direction you anticipate are greatly
increased. If you were trading with the trend and looking for
buy signals on XOM, you would consider buying on the support
bounces off the moving average at the end of June and late July.

Many traders also use the moving average to provide exit signals.
They may be long when the stock is above an uptrending
moving average and then sell when the price crosses below the
moving average or they may be short when the stock is below
a downtrending moving average and then sell when the price
crosses above the moving average.
Exponential Moving Averages

An exponential moving average is also calculated each day by INVESTOR TIP
averaging the closing prices during a specified period of time.
However, the calculation gives more weight to the most recent Exponential moving averages are more
days when determining the average. For example, if you want to volatile than simple moving averages.
apply a 20-day exponential moving average to a stock, you would
take the closing prices for the last 20 periods, including today,
multiply each number by a corresponding weighted percentage—
for example, 1 day ago = closing price x 100%, 2 days ago =
closing price x 95%…20 days ago = closing price x 5%—add
the products together and divide the sum by 20 (the number of
periods you are analyzing). This produces the weighted average
of the past 20 days’ closing prices, which is then plotted on the
chart.
Traders use exponential moving averages when they need faster

signals. The drawback to an exponential moving average is that
it can be much more volatile. This volatility may increase the
number of bad signals as the moving average jumps around.
You can see how an exponential 20-day moving average is more

volatile than a simple 20-day moving average—crossing back and
forth over it—on the Exxon Mobil (XOM) chart shown in Figure
5.2. Some traders believe the stock is losing positive momentum
when the exponential moving average crosses below the simple
moving average and the stock is gaining positive momentum
when the exponential moving average crosses above the simple
moving average.

Figure 5.2—Comparison Between Simple and Exponential Moving Averages on XOM
Applying Moving Averages

Taking trading signals from moving averages can be difficult
because moving averages will always lag a stock’s movement.
Despite the potential difficulties you will face due to this lag,
moving averages are an indispensable tool for technicians. You
can also reduce the impact of these difficulties by using additional
indicators with the moving averages. Let’s discuss two of the most
common uses for moving averages in trading systems.

Trading Method #1: Single Moving

Average
One of the simplest methods involving moving averages is to
use them as a support line in an uptrend and as a resistance line
in a downtrend. Using this method, you would buy the stock as
the price bounces up off support and short the stock as the price
bounces down from resistance.
From the Coca-Cola (KO) chart shown in Figure 5.3, you can see
how looking for confirmation from the 20-day moving average
can increase your probability of a successful trade. The support
created by the uptrending moving average served as additional
confirmation for the bull flag that formed in November. Once
the bull flag hit the support of the moving average, the stock
continued its previous uptrend.
Figure 5.3—Bullish Flag Confirmed by Uptrending Moving Average on KO

Figure 5.4—Fibonacci Retracement Confirmed by Downtrending Moving Average on IP
On the International Paper (IP) chart shown on Figure 5.4,

we have combined a 20-day moving average with a Fibonacci
retracement. As the stock hit the 38 percent, 50 percent and
62 percent resistance levels, it was simultaneously reaching the
resistance of a down-trending 20-day moving average. Its hitting
both the Fibonacci retracement level and the moving average at
the same time should increase your confidence in the trade signal.

Using the moving average to establish potential support and

resistance is also an effective use of the indicator. Moving averages
are generally more responsive than a manual trend line and
can help identify various buy and sell signals. As with many
technical analysis methods, choosing the length of the indicator
is a subjective process. Short-term traders usually like a shorter-
term moving average, such as the 20-day moving average. Mid-
term traders and long-term traders may use a 50-day or 200-day
moving average to correlate with longer-term trades.
The Five Steps for Trading Using a Single Moving

Average
Step 1: Select a stock that is trending—a channeling or very
volatile stock will produce too many false alarms and
will most likely lead to losses.
Step 2: Select a time frame for the moving average—one that

reflects your style of investing.
Step 3: Buy or sell the bounce. Enter a long position when

the stock bounces up from an uptrending moving
average; enter a short trade when the stock bounces
down from a downtrending moving average.
Step 4: Set stops below the moving average when you are long
on a trade and above the moving average when you
are short on a trade. Setting your stop loss 3 percent
to 5 percent above or below the moving average is a
standard stop-loss level and will help prevent you from
exiting too early.
Step 5: Watch for confirmation from oscillators or candlestick

formations when analyzing potential sell or buy signals.

Trading Method #2: Two Moving

INVESTOR TIP Averages
Using two moving averages provides As you saw in method #1, moving averages can provide you with
both support and resistance levels and potential support and resistance levels. Using more than one
buy and sell signals. moving average, however, adds greater credence to the support
and resistance levels created by a single moving average. For this
method, you will couple a shorter-term moving average with a
longer-term moving average. When the shorter-term moving
average is above the longer-term moving average, you should
be bullish. When the shorter-term moving average is below the
longer-term moving average, you should be bearish.
Like method #1, this technique provides context for your trades.
If the moving averages prescribe bullish strategies, then your odds
for success are increased when you go long. If the moving averages
prescribe bearish trades, then your odds for success are increased
when you go short. Using two moving averages makes your
decision-making process much more efficient. The real advantage
of the moving average crossover system is that it encourages you
to participate in every major trend.
As you can see on the S&P 500 Index (SPX) chart shown in
Figure 5.5, the 5- and 20-day moving averages prescribed a buy
at the first of December when the shorter-term moving average
crossed above the longer-term moving average. This trade would
have provided significant profits. The disadvantage of this type
of system manifests itself when the market becomes flat or
very volatile, such as the period between March and June. The
crossovers in a flat market often get you both into the trade too
late and out of the trade too late, which can lead to a series of
breakeven trades or even losing trades. If the channeling lasts
long enough, you may eat up all the profits you made during the
strong uptrend.

Figure 5.5—Two Moving Averages on SPX

Figure 5.6—Two Moving Averages on GE
In the General Electric (GE) chart shown in Figure 5.6, the

10- and 50-day moving averages would have kept you in trades
for longer periods of time and helped you avoid a potential
channeling period from June through August. Using a longer
moving average can make your winning trades larger, but your
losses may also be larger.
If you can determine when a stock is trending and when it is

channeling sideways, you can decide when it would be most
advantageous to use moving averages and when it would be better
to use another method. Distinguishing between these two market
conditions can be difficult, so trading with another indicator,
such as an oscillator, can be a great supplement when using
moving average crossovers.

The 5 Steps for Trading Using Two Moving Averages

may lead to losses.

Step 3: Buy or sell the crosses. Exit any short positions or buy
long when the shorter-term moving average crosses
above the longer-term moving average; exit any long
positions or sell short when the shorter-term moving
average crosses below the longer-term moving average.
Step 4: Set stops below the support of the shorter-term

moving average when long and above the shorter-term
moving average when short. Setting your stop loss 3
percent to 5 percent above or below the shorter-term
moving average is a standard stop-loss level and will
help prevent you from exiting too early. Although it is
more likely that a crossover will signal your exit, the
market may move very quickly and a stop may be hit
during a dramatic move before the moving averages
have had a chance to adjust.

Moving Average Envelopes

Moving average envelopes are effective tools not only for
identifying support and resistance, but also for helping to
INVESTOR TIP
establish limits and stops. You create a moving average envelope
by plotting a simple moving average and then plotting two Moving average envelopes provide
both profit target and stop-loss levels.
additional lines parallel to the moving average—one line above
the moving average line and one line below the moving average
line. The two parallel lines are separated from the moving average
line by a set percentage determined by you. The two parallel lines,
the upper and lower boundaries, create the envelope.

Figure 5.7—Moving Average Envelope on DIA
Trading Method #3: Moving

Average Envelopes
Moving average envelopes create helpful support and resistance
levels for your trading decisions. When the stock price bounces
up off the moving average, you can set your profit target at the
upper boundary and set your stop loss at the lower boundary.
This provides a rough guide for how much risk versus reward you
are willing to take.
You can also use a moving average envelope to identify new or

prolonged trends. A technician would consider it significant if a
stock breaks out of its normal envelope range and begins trending
above or below that boundary.
In the Diamonds (DIA) chart shown in Figure 5.7, you have a

20-day moving average with a 3 percent envelope. The stock price
crossed the uptrending 20-day moving average on 11/26. At the

Figure 5.8—Moving Average Envelope on PFE
time, the upper boundary was at about $100.50, for a potential

profit of $2.50. The stock easily hit that level within a few weeks
and you may have even stayed in the trade for a while longer with
a trailing stop loss. The market bounced off the moving average
again on 1/13 with the upper boundary at $107, leaving $2 of
potential profit. The market hit that level before pulling back in
late January.
In the Pfizer (PFE) chart shown in Figure 5.8, the stock price
bounced down from a downtrending moving average on 6/14 and
hit your target of $2 ($35.50 – $33.50 = $2.00) near the end of
June. Once the stock price hits your price target, you can decide
if you want to exit the trade, place a trailing stop loss on the trade
or exit the trade when a shorter-term moving average crosses back
above the longer-term moving average—provided you have two
moving averages on your chart. Exiting immediately is the most
conservative approach, while staying in the trade allows you to
potentially realize greater profits.

Figure 5.9—Moving Average Envelope on GM
In the General Motors (GM) chart shown in Figure 5.9, the

stock price broke out of its upper boundary and began rising
on 12/03. Once the stock price has broken above the upper
boundary, the stock’s moving average can be used as a stop loss.
In the case of GM, doing so would have caused you to exit the
trade on 1/28 for a substantial profit. Using the moving average
as a stop-loss level once the stock price has broken above the
upper boundary or below the lower boundary, allows you to take
advantage of the profit-making opportunities created by longer-
term trends.
The 7 Steps for Trading Using Moving Average

Envelopes
may lead to losses.


Step 3: Select the envelope width. Most stocks channel within

a range of 3 percent to 5 percent; testing different
bandwidths on a stock will help identify the best fit.

the market bounces up from an uptrending moving
average or uptrending lower boundary. Enter a
short trade when the security bounces down from a
downtrending moving average or downtrending upper
boundary.
Step 5: Set stops at or just below the lower boundary when

you go long or at or just above the upper boundary
when you go short. Based on your analysis, you know
that these levels are less likely to be broken and should
provide enough room for the stock to move without
forcing you to exit early.
Step 6: Set limits at the upper boundary when the price

bounces off an uptrending moving average; set limits
at the lower boundary when the stock price bounces
down from a downtrending moving average. Using
a trailing stop, rather than exiting at the upper or
lower boundary target every time, will help you take
advantage of prolonged trends.

Bollinger Bands
Bollinger bands are similar to moving average envelopes with one INVESTOR TIP
key distinction: they reflect volatility. You construct Bollinger
bands by applying a simple moving average (usually 20 days) to Bollinger bands provide responsive
support and resistance levels because
a stock and then applying an envelope to the moving average,
they take volatility into account.
with each side of the envelope placed two standard deviations—a
statistical term used for telling you how tightly all the various
examples are clustered around the mean in a set of data—of
historical volatility away from the moving average. This means
the range between the two Bollinger bands at any given time
represents 95 percent of the price movement or trading range, for
the last 20 days. Each of the strategies using Bollinger bands relies
on the indicator’s excellent ability to identify levels of volatility.

Figure 5.10—Bollinger Bands on INTC
Trading Method #4: Trend

Following
Periodically the price of a stock will rise or fall to one of the
Bollinger bands and begin climbing or falling along the upper or
lower band. This indicates an escalating trend and can be used as
a buy or short signal. To avoid whipsaws, you could wait to enter
the trade until the market retraces and bounces off the center
moving average or opposite band to signal the buy or sell.
In the Intel (INTC) chart shown in Figure 5.10, the stock price
bounced off its downtrending 20-day moving average on 2/13.
This signaled a possible entry. As the stock followed the lower
band, you probably would not have exited the trade until a break
of the 20-day moving average on 4/02. However, an earlier exit
could have been taken when the lower band began trending back
up toward the 20-day moving average. This is a common signal
that indicates volatility is declining and the bands are starting to
narrow. This occurred on 3/29. This is a concept we will discuss
further with the “squeeze” strategy.

Figure 5.11—Bollinger Bands on ORCL
As you can see on the Oracle (ORCL) chart shown in Figure

5.11, you could have purchased ORCL when it bounced up off
the uptrending moving average on 12/31. The stock exceeded the
upper band and “walked” along the band for the next two weeks.
You could have identified an exit either when the stock price
crossed below the moving average or when the upper band began
to trend back down toward the moving average, narrowing the
bandwidth, on 1/27.

The 7 Steps for Trading Using the Trend and

Bollinger Bands
Step 1: Select a stock that is trending. A channeling or very
may lead to losses.
Step 2: Select a time frame for the moving average—Bollinger

bands have been designed to use a 20-day moving
average. The time frame can be extended, but this is
not recommended.
Step 3: Select the width of the Bollinger bands—Bollinger

bands have been designed to be placed two standard
deviations of the historical volatility away from the
mean price. The width can be expanded or narrowed,
but this is not recommended.

the market bounces up from an uptrending moving
average; enter a short trade when the security bounces
down from a downtrending moving average.
Step 5: Set stops at or just below the opposite band. Based on

your analysis, you should know this level is less likely
to be broken and should provide enough room for the
stock to move without causing you to exit early.
Step 6: Identify exits. Exit the trade when the stock crosses the
moving average; this will keep you in most of the major
trends. You can also set an earlier exit that is signaled
when the upper band turns down in an uptrend or the
lower band turns up in a downtrend; this indicates the
end of the trend and may help preserve gains.

INVESTOR TIP Trading Method #5: The Squeeze

The longer the market trades within The “squeeze” takes advantage of sudden increases in volatility
a narrow range, the more volatile the that generally occur after periods of constrained volatility. When
subsequent breakout should be. a stock trends in a flat range, the bands begin to constrict and
eventually become very narrow. In most cases, when a stock
price has been constrained for a prolonged period of time, the
stock price will eventually explode out of its trading range.
This increased volatility causes the Bollinger bands to widen
dramatically.

Figure 5.12—Squeeze Play on .DJI
You can identify potential squeeze plays when the Bollinger bands
constrict to their narrowest position over the last 4–6 months.
The stock breaking out of this new narrow range, accompanied
by a dramatic increase in the Bollinger bandwidth, signals the
entry point for the trade.
Had you looked at the chart shown in Figure 5.12, you would
have been alerted to a potential squeeze as the Dow Jones Index’s
(.DJI) bandwidths constricted on 3/05 to their narrowest position
in the past five months. The buy signal occurred as the market
broke down from the channel on 3/08. An easy way to identify
such a break is to notice when the bands begin to trend in
opposite directions from each other.

Setting a limit or stop order is particularly important when

making a squeeze play because the breakout does not necessarily
indicate a new trend. Using a trailing stop or watching for a
bounce off support or resistance may provide a good exit signal.
You may also consider using the price crossing back over the
moving average as an exit signal. We will also discuss in Section
6 how oscillators may be used to indicate a sell signal after a
squeeze.
Figure 5.13—Squeeze Play on MSFT
As shown in Figure 5.13, Microsoft (MSFT) reached a potential

squeeze with its narrowest bandwidth in more than six months
on 6/07. The breakout occurred as the market moved past resis-
tance on a bounce off the 20-day moving average. You can use a
trailing stop as the market moves up to maximize gains. You can
also identify additional sell signals by looking for a break of the
moving average or looking for the upper band to begin trending
back down. This second sell signal occurred in early July.
Because it is concerned with volatility and not direction, the

squeeze is one of the most popular methods available for trading
Bollinger bands.

The 5 Steps for Trading Using the Squeeze

Step 1: Select a stock with relatively low volatility compared to
its recent past (4–6 months).
Step 2: Look for narrow bandwidth. To reflect this low

volatil-ity, the Bollinger bands should be at their
narrowest over the past 4–6 months.
Step 3: Wait for the breakout. The stock will eventually break
out of its narrow channel and the Bollinger bands will
widen dramatically—you should trade the direction
of the breakout. The breakout can be identified
using oscillators, a break in support or resistance or
candlestick formations. It can also be identified when
both bands begin trending in opposite directions,
widening the spread.
Step 4: Look for the exit. When the market begins to hit
resis-tance or the Bollinger bands begin to trend back
together, you should exit the trade. You can also use a
trailing stop or a break of the moving average for an
exit.


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Advanced Technical

“The trick is to differentiate between

Moving Average Envelopes

82 INVESTools Investor Education®

Trending indicators can be used alone or they can be used in

To mitigate the risk of being whipsawed, you should consider

© 2006 INVESTools Inc. All rights reserved. 83

Figure 5.1—Simple Moving Average on XOM

Simple Moving Averages

84 INVESTools Investor Education®

Exponential Moving Averages

Traders use exponential moving averages when they need faster

You can see how an exponential 20-day moving average is more

© 2006 INVESTools Inc. All rights reserved. 85

Figure 5.2—Comparison Between Simple and Exponential Moving Averages on XOM

Applying Moving Averages

86 INVESTools Investor Education®

Trading Method #1: Single Moving

Figure 5.3—Bullish Flag Confirmed by Uptrending Moving Average on KO

© 2006 INVESTools Inc. All rights reserved. 87

Figure 5.4—Fibonacci Retracement Confirmed by Downtrending Moving Average on IP

On the International Paper (IP) chart shown on Figure 5.4,

88 INVESTools Investor Education®

Using the moving average to establish potential support and

The Five Steps for Trading Using a Single Moving

Step 2: Select a time frame for the moving average—one that

Step 3: Buy or sell the bounce. Enter a long position when

Step 5: Watch for confirmation from oscillators or candlestick

© 2006 INVESTools Inc. All rights reserved. 89

Trading Method #2: Two Moving

90 INVESTools Investor Education®

Figure 5.5—Two Moving Averages on SPX

© 2006 INVESTools Inc. All rights reserved. 91

Figure 5.6—Two Moving Averages on GE

In the General Electric (GE) chart shown in Figure 5.6, the

If you can determine when a stock is trending and when it is

92 INVESTools Investor Education®

The 5 Steps for Trading Using Two Moving Averages

Step 2: Select a time frame for the moving average—one that

Step 4: Set stops below the support of the shorter-term

Step 5: Watch for confirmation from oscillators or candlestick

Moving Average Envelopes

© 2006 INVESTools Inc. All rights reserved. 93

Figure 5.7—Moving Average Envelope on DIA

Trading Method #3: Moving

You can also use a moving average envelope to identify new or

In the Diamonds (DIA) chart shown in Figure 5.7, you have a

94 INVESTools Investor Education®

Figure 5.8—Moving Average Envelope on PFE

time, the upper boundary was at about $100.50, for a potential

© 2006 INVESTools Inc. All rights reserved. 95

Figure 5.9—Moving Average Envelope on GM

In the General Motors (GM) chart shown in Figure 5.9, the

The 7 Steps for Trading Using Moving Average

Step 2: Select a time frame for the moving average—one that

96 INVESTools Investor Education®

Step 3: Select the envelope width. Most stocks channel within

Step 4: Buy or sell the bounce. Enter a long position when

Step 5: Set stops at or just below the lower boundary when

INVESTOR TIP Trading Method #5: The Squeeze