Technical Analysis Of Stocks And Commodities Using Basic Indicators
Last weekend I was asked by numerous traders who practice technical analysis of stocks and commodities, what indicator I preferred to use the most. The answer was the Exponential Moving Average or (EMA) for short. I demonstrated yesterday how to use the EMA to measure pullbacks away from the main trend. The method is rather simple but works remarkably well for finding stocks and other markets that are trending and more importantly measuring a pullback away from the trend.
In a nutshell we found a stock that was trending strongly above the 20 Day EMA and waited for the stock to trade completely below the 20 day EMA. We waited a few days for the stock to come back completely above the moving average, and I don't recommend you wait more than 5 days for this event to occur. In other words once the stock drops completely below the 20 day EMA, you should wait no more than 5 trading days for the stock to rally above the 20 day EMA. You can see the entire process that I just described in this chart. The market first rallied above the 20 day EMA then traded below the 20 day EMA and finally within 2 days traded completely above the 20 day EMA.
Today I'm going to show you the correct way to enter this strategy and where to place your stop loss order. I highly suggest you pick stocks, futures or forex markets that are going through volatile periods. Most swing trading methods require strong volatility and this method is no exception. You can see in this example how Facebook stock began trading well above the 20 day EMA before moving completely below the average. The stock stayed below the EMA for less than 2 trading sessions. Remember you never want the stock or other market you are trading to stay below the average for more than 5 trading days.
Once the market trades back above the EMA we want of find a strategic entry point so that we don't get stopped out randomly due to market noise. I prefer to place my entry order immediately above the first bar that trades completely back above the EMA. I place a buy stop order $.025 cents above the high that was achieved the first day the stock trades completely above the EMA. Although I'm using stocks in this example, the method applies to commodities, futures and currencies as well.
You want to make sure to monitor the market and make sure you cancel your entry stop order if the trade doesn't fill the first day after you place your stop order. You want to see strong momentum coming back into the market after the cross over above the EMA occurred. If the market doesn't move straight up the odds are the set up is weak and you may want to look at other stocks or markets.
I want to place my stop loss order at a strategic level so that I don't get stopped out prematurely due to volatility and market noise. One of the biggest reasons many trades don't work out is because the stop loss level is not placed at a strategic level. There's nothing more frustrating that watching your favorite market or stock get stopped out only to see a strong continuation in your direction. Make sure you place your stop loss order at the moving average price level immediately between the first bar completely below the EMA and the first bar immediately above the EMA. This may sound a bit confusing so I provided an example for you to see exactly where the stop loss level would be.
Just in case the example above was a bit confusing I'm going to confuse you even more by showing you the entire sequence from the short side. I'm just kidding about the confusing you more part. I really think it's a good idea to see how the set up looks visually from the long side as well as the short side. Notice in this particular example the stock only stayed above the moving average for 3 trading days.
Remember the stop loss placement goes at the moving average level between the first bar outside of the moving average and the first bar inside the moving average. You can see both bars identified in this graph.
Now that you know how to identify the set up and the first bar inside and outside of the moving average, you should place your stop loss at the moving average level of the area immediately between the two bars. You can get a good idea from this graph exactly where the stop loss level is placed. This is a buy stop not a stop loss because we are selling short.
Tomorrow I will conclude this three part series on building a complete strategy using the 20 day EMA. We are going to go over profit targets and I will show you the best way to calculate your profit target levels for this strategy. For more on this topic, please go to: Breakout Trading Strategies 101 and Technical Analysis Trading - Double Tops And Bottoms
Wishing you the best
By Roger Scott