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Moving averages are one of, if not, the first indicator that people are introduced to. They are simple to calculate, simple to understand and they seemingly smooth out the price on a chart, painting beautifully rounded hills and valleys. Most plot them right on the price chart and use them to show areas of support or resistance. See!, they say, price hit the 200 day moving average, that’s resistance!
Being a rebel, I use moving averages differently. First, I try to not plot them on top of my price charts since I prefer to keep the chart clean of any distractions. Price is the main feature and everything else keys off it. So why create distractions from the most important element?
Second, I refer to moving averages to find areas of extreme expansion. Think of price as an elastic band that can stretch above and below the moving average. As it does, it reaches a point where it just can’t stretch any further and starts to snap back. Mean reversion for the more mathematically inclined.
So what I do is modify the MACD to show this elastic character of prices. Moving Average Convergence Divergence (MACD) is probably the next most common indicator after moving averages. And yet most people have neither any understanding of how it is calculated nor how they should use it. To have the MACD indicator plot the movement of price away from a moving average change the default setting to: 1, X, 1 — where X stands for the period of the moving average you want.
Let me show you how I use this. I mentioned that I liked North West Company Fund (NWF.un) in June 2006 (note that in Sept 2006 there was a 3:1 split). Last year, the Canadian income trust market reacted with panic selling on Halloween as the Harper government reneged on their promise to not tax income trusts. Without any shame, they lied to the Canadian people. But what politician hasn’t?
North West wasn’t spared as it gapped down hard on very high volume. There was panic in the sector as the ground has suddenly shifted. Sentiment was very negative with many claiming this was the death knell for income trusts in general. I bought at $13.55 (all prices in Cdn dollars). That would be the green dot on the chart.
There was a momentary recovery and a second spike down. Such a move leads to a double bottom or a further decline - either way, a clear technical would tell me and I would limit any potential losses. It’s important to remember that North West’s business was humming along with great earnings. And I knew that I would be paid a distribution as I waited for cooler heads to prevail.
See the chart above the price chart for North West? That is the relative behavior of price to the 50 day simple moving average. By the way, there is nothing magical about the 50 moving average, it wouldn’t make a difference if you used the 33, 40, 43, etc. moving averages. Consistency is important though since we don’t want to compare apples to oranges.
Notice how the previous swing high in September 2006 was stopped as price was stretched to the upside (red rounded box). The November spike down was the mirror opposite of that situation. Of course, price simply can not bounce from one extreme (oversold) to the next extreme (overbought) within a short time. Especially when we’re dealing with a low beta security like an income trust. So I sat. And my sitting, as Jesse Livermore would say, made money. I got out a few days ago at $20.28 .
Here are the fills I got from Interactive Brokers:
NWF.UN 2006-11-13, 14:07:22 TSE 13.5500
NWF.UN 2007-04-30, 11:14:14 TSE 20.2800
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