Simple Moving Average Trading Strategy - Pivot Method

THE SIMPLE MOVING AVERAGE  

The simple moving average (the arithmetic mean) is the most popular moving average used in technical analysis. The simple moving average is the sum of the closing prices over a period of sessions divided by the number of sessions. For example, a 10-day moving average would be the sum of the past 10 days’ closing prices divided by 10. Each new day would drop the first day’s closing price and add the new day’s closing price. As new data is added to the calculation, old data is removed. By averaging the price data, a smoother line is produced, and the trend is much easier to recognize. The disadvantage of the simple moving average is that it only takes into account the time period of the sessions covered in the calculation and that it gives equal weight to each day’s price.

In Chapters 4 and 5, we covered the pivot point formulas and the significance of pivot points as support and resistance. As you will recall, the pivot point calculation provides the mean (average) for the session’s trading range, or high, low, and close: (H + L + C)/3.

This moving average section discusses how the moving average helps clarify the market’s price flow by extending price analysis over a certain period of time. In this manner, moving averages can accentuate when a market enters an extreme condition by how far it departs from the mean. Price action either will move toward the moving average or will return to the moving average to retest that level.

The “Market Direction” number that was shown in the Excel sheet in Figure 5.8 is a combination of the use of price session information (pivot point number) over a period of time (moving average). The market direction number utilizes cumulative data from the high, the low, and the close for a session. This information provides a clear picture of the “average true price” for that time period. The market direction number is then calculated by taking the average pivot number from the past three periods. Any time frame can be utilized to calculate the number. However, the longer the time frame, the more significance the number will hold. To calculate the market direction number, add three pivot points from the same session, and divide the sum by three. The purpose of using the pivot point in the moving average calculation is that the pivot point will show the continuance of the trend.

Market Direction =Pivot + Pivot + Pivot/3

As stated previously, the market direction number, which is a three period pivot point moving average, can act as a support number in bullish conditions and has a high degree of importance when one of the pivot point calculations for the current session coincides with or is near that number. The market direction number holds true as a resistance number in a bear market condition. If another number coincides with the market direction number, such as the actual pivot point or an R-1 (resistance level one) number, then it would serve as the target high number for that specific time period. Another way of using the three-period pivot point moving average is as a point of reference or fair value. For example, when the market price departs, or deviates, too far from the mean, then you can use the extreme resistance or support number, such as R-2 or S-2 (support level two), or the farthest target number of that direction, as a potential turning point. When various time frames are incorporated into the analysis (daily, weekly, and monthly), there is more certainty that the target price level can generate the anticipated reaction. If the market gaps too far from the daily pivot point moving average, use the monthly and/or weekly target support and resistance numbers to help identify a targeted reversal support or resistance point. Figure 6.1 shows a spot foreign exchange (forex) British pound daily chart with the three-period pivot point moving average overlaid on top of prices. Notice that as the market changes conditions from bearish (downtrend) to bullish (uptrend), prices bounce off the moving average as a support line and then trade off the moving average as it acts as a ceiling of resistance. If you notice the price action from November 15 to November 25, you will see that the market entered a consolidating phase as prices moved above and below the moving average. The moving average went virtually in a flat line with a bias to an upside slope. This was hinting that prices were getting ready to change direction. When you watch the moving average in relation to the underlying price action, sometimes you can get clues as to the true market price direction using the pivot point moving average. Due to the weighting of the high, low, and close combined, the moving average factors in the typical price of that time period, thus giving a better gauge of market value. If the close is closer to the high, the average will be at a higher assigned value. Using the three-period pivot point will help you filter out much of the market noise and will give you a truer sense of the market’s fair value within the price range of the past three trading periods.

At times, the slope, or angle, of the moving average can give you a clue as to the market’s true strength or weakness, especially when combined with candlestick charting.

 The slope helps filter out the noise, and you can see if the market’s value is progressively appreciating or depreciating. When a market goes from the trending phase into the consolidation phase, it is the slope of the pivot point moving average that can help you identify the potential price direction the market makes next from the consolidating phase, such as if the market will make a continuation or a trend reversal move. For added clarity, when combined with identifying a high probability bottom or top-forming candle, you have added confirmation of a potential move.

In Figure 6.2, the graph shows a representation of a pivot point moving average in a declining trend phase. Then as prices consolidate as the pivot point average measures the typical price rather than the close, we can determine what the true market value is and which way prices tend to be moving. Markets sometimes demonstrate extreme volatility at turning points, and the moving average approach can help filter out the noise inflicted by wide price swings. These swings often lead to confusion or worse—traders getting whipsawed, causing loss in trading equity.

As the moving average slopes up, it indicates that the market values are also tending to trade higher. Eventually, we see a trend reversal, which is what the direction of the moving average indicated.

In Figure 6.3, let’s look at a five-minute chart on the Chicago Board of Trade (CBOT) mini-Dow contract. Just to clarify, the minimum tick fluctuation is a one-point move, and every point is worth $5. So the overall contract value is $5 times the index. If the Dow is at 10500, the contract value is $52,500. This may not make sense now, but as you read the book further, you will understand what the low close doji sell signal is about and what the specific rules are for entering on this pattern. For purposes of illustrating what phase a market goes in and how the pivot point moving average can help you follow a market, let’s look at the sequence of events:

• The market develops into a downtrend.
• At the bottom, a bullish reversal candle pattern forms.
• Prices start trading wildly, but the moving averages (M/As) are sloping higher.
• The market reverses and then goes into a sideways channel or consolidating phase. (If you examine the pivot point moving averages, you will see they were pointing higher while prices were in the congestion phase.)
• Prices finally break out and continue the uptrend.

This chart was from 2/10/2006; prices went on to trade that day as high as 10963. The moving averages did alert you to the internal strength, and the price direction did continue higher—a pretty good method for getting a clue to the market’s next move.

In Figure 6.4, we have the CBOT mini-Dow contract, which shows that the market was coming out of the congestion, or consolidation, period in late October. The three-period pivot point moving average was also flat-lining with an upward slope in the direction of the moving average. Once the market made a break for it by establishing the uptrend, the average helped identify the trending condition. As the chart illustrates, the pivot point moving average actually hugs the market’s lows when in an uptrend and the highs in a downtrend. It also helps to identify the conditional changes when the market makes reversals.

This moving average approach works just as well for active day trading markets, such as the e-mini-Standard & Poor’s (S&P) shown in the 5- minute chart in Figure 6.5, as it does for swing or position traders.

This method can help active day traders to see and to confirm changes in price conditions, such as when the market is in a consolidating period to trending mode. Notice how the moving average acts as a support once the market starts the breakout in the uptrend.

The three-period pivot point moving average works as a tool to confirm triggers and exits by price action closing above or below the moving average pivot line. In Figure 6.6, we have a 15-minute chart on the spot forex Japanese yen currency. As the market forms a bottom at 9:00 A.M., notice how the moving average shows a cup formation and that the price of the market closes above the moving average. This gives us a clue that the market is starting to change from a bearish trend condition to a consolidating phase and that the market is starting to move into a reversal of the current trending condition. As the market starts to establish higher highs and higher lows, it also is closing above prior highs and, most important, closing above the three-period pivot point moving average. Now the average starts to act as a support target until prices reach the top, and the moving average starts to flat-line again as prices go into another consolidating phase. The Japanese yen chart provides a good example of a high close hammer trigger, confirmed by the price closing above the moving average pivot line.