reason for thisshould become apparent as one works with the different timedimensions. If the analyst begins with only the near term picture, heor she is forced to constantly revise conclusions as more price datais considered. A thorough analysis of a daily chart may have to becompletely redone after looking at the long range charts. By starting186 Chapter 8
with the big picture, going back as far as 20 years, all data to be con-sidered are already included in the chart and a proper perspective isachieved. Once the analyst knows where the market is from a longerrange perspective, he or she gradually “zeros in” on the shorter term.
The first chart to be considered is the 20 year monthly chart.The analyst looks for the more obvious chart patterns, major trend-lines, or the proximity of major support or resistance levels. He or shethen consults the most recent five years on the weekly chart, repeat-ing the same process. Having done that, the analyst narrows his orher focus to the last six to nine months of market action on the dailybar chart, thus going from the “macro” to the “micro” approach. Ifthe trader wants to proceed further, intraday charts can then be con-sulted for an even more microscopic study of recent action.
WHY SHOULD LONG RANGECHARTS BE ADJUSTEDFOR INFLATION?
A question often raised concerning long term charts is whether ornot historic price levels seen on the charts should be adjusted forinflation. After all, the argument goes, do these long range peaksand troughs have any validity if not adjusted to reflect thechanges in the value of the U.S. dollar? This is a point of somecontroversy among analysts.
I do not believe that any adjustment is necessary on theselong range charts for a number of reasons. The main reason is mybelief that the markets themselves have already made the necessaryadjustments. A currency declining in value causes commoditiesquoted in that currency to increase in value. The declining value ofthe dollar, therefore, would contribute to rising commodity prices.A rising dollar would cause the price of most commodities to fall.
The tremendous price gains in commodity markets duringthe 1970s and declining prices in the 1980s and 1990s are classicexamples of inflation at work. To have suggested during the 1970sthat commodity price levels that had doubled and tripled in priceshould then be adjusted to reflect rising inflation would make nosense at all. The rising commodity markets already were a mani-festation of that inflation. Declining commodity markets sinceLong Term Charts 187
the 1980s reflect a long period of disinflation. Should we take theprice of gold, which is now worth less than half of its value in1980, and adjust it to reflect the lower inflation rate? The markethas already taken care of that.
The final point in this debate goes to the heart of the tech-nical theory, which states that price action discounts everything,even inflation. All financial markets adjust to periods of inflationand deflation and to changes in currency values. The real answerto whether long range charts should be adjusted for inflation liesin the charts themselves. Many markets fail at historic resistancelevels set several years earlier and then bounce off support levelsnot seen in several years. It’s also clear that falling inflation sincethe early 1980s has helped support bull markets in bonds andstocks, It would seem that those markets have already made theirown inflation adjustment. (See Figure 8.1.)
 
bra179 (“DWI X) Dow Industrials
 
Dow Industriais
 
 
 
 
fo es ee ee
 
 
Figure 8.1 The gold price peak in 1980 ushered in two decades of lowinflation. Low inflation normally causes falling gold prices and rising stockprices as this chart shows. Why adjust the charts again for inflation? It’salready been done.188 Chapter 8
 
LONG TERM CHARTS NOTINTENDED FOR TRADINGPURPOSES
Long term charts are not meant for trading purposes. A distinc-tion has to be made between market analysis for forecasting pur-poses and the timing of market commitments. Long term chartsare useful in the analytical process to help determine the majortrend and price objectives. They are not suitable, however, for thetiming of entry and exit points and should not be used for thatpurpose. For that more sensitive task, daily and intraday chartsshould be utilized.
EXAMPLES OF LONGTERM CHARTS
The following pages contain examples of long term weekly andmonthly charts (Figures 8.2-8.12). The drawings on the charts arelimited to long term support and resistance levels, trendlines, per-centage retracements, weekly reversals, and an occasional pricepattern. Be aware, however, that anything that can be done on adaily chart can also be done on a weekly or monthly. We'll showyou later in the book how the application of various technicalindicators to these long term charts is accomplished, and how sig-nals on weekly charts become valuable filters for shorter term tim-ing decisions. Remember also that semilog chart scaling becomesmore valuable when studying long range price trends.(*SOX) Phix Semiconductor Index
 
Weekly Bar Chart
 
 
 
 
Figure 8.2 This chart of semiconductor stocks shows the valuable per-spective of a weekly chart. The late 1997 price fall stopped right at the 62%retracement level and bounced off chart support formed the previous spring(see circle).
 
10/08/93 (GM) General Mtrs Corp
 
Weekly Bar Chart
 
 
 
 
 
 
Figure 8.3 The early 1998 bottom in General Motors began right at thetrendline drawn along the 1995-1996 lows. That’s why it’s a good idea totrack weekly charts. 
12131197
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Wy iMo Ty i ! Mi
 
 
 
 
gers 84 This monthly c cha art shows the 1997 rally in Burlingtonstopping right at the elev vel that stopped ed the 15890 nd 1993valles The 1996 Pott ttom was at the e level a 1991 bottom. Whosays charts don ry?
 
 
 
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Figure 0 Ltd. during the 1997 ra ray 60 ‘ould havben mefite ef m tl the in vale edge t thet the 1989, 1991, and 1 tops $ occurredright 
pt 3173 (IBM) international Busines
Monthly Bar Chart
Long Term Support Near 20
YZh a
Figure 8.6 Do long term charts matter? The 1993 bottom in IBM was atthe same level as the bottom formed 20 years earlier in 1974. The break ofan 8 year down trendline (see box) in 1995 confirmed the new majoruptrend,
 
 
 
 
 
 
priate (HP) Helmerich & Payne inc
Monthly Bar Chart
Resistance
Resistance
 
 
 
 
foto 1 ss os es or eos ee a)41:1 Prin vag WadoBlon @ Oras Pasoarch
 
 
Figure 8.7 Helmerich & Payne finally broke out above 19 in 1996 afterfailing in 1987, 1990, and 1993. The late 1996 pullback at 28 occurrednear the 1980 peak. 
(DJ) Dow Jones & Co inc
 
| ane
Neckline
 
Left Shoulder
at .
NW \ i
Ie Shoulder
Tang
 
 
 
 
 
| / iH -af | i" fyi
 
 
 
Figure 8.8 This monthly chart of Dow Jones shows a head and shouldersbottom forming for 10 years from 1988 to 1997. The right shoulder also hasthe shape of a bullish ascending triangle. The breakout over the neckline at
42 completed the bottom.
 
foars0/01
(LUV) Southwest Airls Co
 
Monthly Bar Chart
iei
3 1/2 Year Symmetricel Triangle
MY halt
 
 
 
 
 
 
Figure 8.9 A bullish symmetrical triangle was easy to spot on themonthly chart of Southwest Airlines. But you probably wouldn’t have spotted
it on a daily chart. 
bao
 
Monthly Bar Chart
20 Year Up Trendline
 
 
 
 
Figure 8.10 The 1994 bottom in the Dow Utilities bounced off a trend-line lasting 20 years. There are those who claim that past price action has nobearing on the future. If you still believe that, go back and look at these longterm charts again.
 
13179 ("TNA) Tokyo Nikkei Dow
Monthly Bar Chart
 
 
 
 
 
 
io ess ee ee ee
Figure 8.11 On this linear-scaled chart of the Japanese stock market, thelong term up trendline (line 1) drawn under the 1982 and 1984 lows was brokenin early 1992 (see circle) near 22,000. That was two years after the actual peak.194 Chapter 8
 
b1ra179 (*TNA) Tokyo Nikkei Dow
 
Monthly Bar Chart
 
ne eS se ee ee el
 
 
Figure 8.12 The same Japanese chart from Figure 8.11 using log scaling.Line 1 is the trendline from the previous figure. The steeper line 2 was brokenin mid-1990 (see box) at 30,000. Up trendlines on log charts are brokensooner than linear up trendlines. 
INTRODUCTION
The moving average is one of the most versatile and widely used ofall technical indicators. Because of the way it is constructed andthe fact that it can be so easily quantified and tested, it is the basisfor many mechanical trend-following systems in use today.
Chart analysis is largely subjective and difficult to test. Asa result, chart analysis does not lend itself that well to computer-ization. Moving average rules, by contrast, can easily be pro-grammed into a computer, which then generates specific buy andsell signals. While two technicians may disagree as to whether agiven price pattern is a triangle or a wedge, or whether the volumepattern favors the bull or bear side, moving average trend signalsare precise and not open to debate.
Let’s begin by defining what a moving average is. As the sec-ond word implies, it is an average of a certain body of data. Forexample, if a 10 day average of closing prices is desired, the pricesfor the last 10 days are added up and the total is divided by 10.The term moving is used because only the latest 10 days’ prices are
195196 Chapter 9
used in the calculation. Therefore, the body of data to be averaged(the last 10 closing prices) moves forward with each new tradingday. The most common way to calculate the moving average is towork from the total of the last 10 days’ closing prices. Each daythe new close is added to the total and the close 11 days back issubtracted. The new total is then divided by the number of days(10). (See Figure 9.1a.)
The above example deals with a simple 10 day movingaverage of closing prices. There are, however, other types of mov-ing averages that are not simple. There are also many questions asto the best way to employ the moving average. For example, howmany days should be averaged? Should a short term or a longterm average be used? Is there a best moving average for all mar-kets or for each individual market? Is the closing price the bestprice to average? Would it be better to use more than one average?
 
11/14/97 (*SPX) S&P 500 Stock Index
 
Daily Bar Chart
10 Day MovingAvarage
 
 
 
 
 
 
Figure 9.la_ A 10 day moving average applied to a daily bar chart of theS&P 500. Prices crossed the average line several times (see arrows) before final-ly turning higher. Prices stayed above the average during the subsequent rally.Moving Averages 197
Which type of average works better—a simple, linearly weightedor exponentially smoothed? Are there times when moving aver-ages work better than others?
There are many questions to be considered when usingmoving averages. We'll address many of these questions in thischapter and show examples of some of the more common usagesof the moving average.
THE MOVING AVERAGE:A SMOOTHING DEVICE WITHA TIME LAG
The moving average is essentially a trend following device. Its pur-pose is to identify or signal that a new trend has begun or that anold trend has ended or reversed. Its purpose is to track theprogress of the trend. It might be viewed as a curving trendline. Itdoes not, however, predict market action in the same sense thatstandard chart analysis attempts to do. The moving average is afollower, not a leader. It never anticipates; it only reacts. The mov-ing average follows a market and tells us that a trend has begun,but only after the fact.
The moving average is a smoothing device. By averagingthe price data, a smoother line is produced, making it much easi-er to view the underlying trend. By its very nature, however, themoving average line also lags the market action. A shorter mov-ing average, such as a 20 day average, would hug the price actionmore closely than a 200 day average. The time lag is reduced withthe shorter averages, but can never be completely eliminated.Shorter term averages are more sensitive to the price action,whereas longer range averages are less sensitive. In certain typesof markets, it is more advantageous to use a shorter average and,at other times, a longer and less sensitive average proves moreuseful. (See Figure 9.1b.)
Which Prices to Average
We have been using the closing price in all of our examples so far.However, while the closing price is considered to be the most198 Chapter 9
 
 
04/03/97 (*SPX) S&P 500 Stock Index
 
Daily Bar Chart
20 Day Average
200 Day Average
 
 
 
 
A rarer ane a aT
 
Figure 9.1b A comparison of a 20 day and a 200 day moving average.During the sideways period from August to January, prices crossed the shorteraverage several times. However, they remained above the 200 day averagethroughout the entire period.
important price of the trading day and the price most commonlyused in moving average construction, the reader should be awarethat some technicians prefer to use other prices. Some prefer touse a midpoint value, which is arrived at by dividing the day’srange by two.
Others include the closing price in their calculation byadding the high, low, and closing prices together and dividingthe sum by three. Still others prefer to construct price bands byaveraging the high and low prices separately. The result is twoseparate moving average lines that act as a sort of volatility bufferor neutral zone. Despite these variations, the closing price is stillthe price most commonly used for moving average analysis andis the price that we'll be focusing most of our attention on in thischapter.Moving Averages 199
The Simple Moving Average
The simple moving average, or the arithmetic mean, is the type usedby most technical analysts. But there are some who question itsusefulness on two points. The first criticism is that only the peri-od covered by the average (the last 10 days, for example) is takeninto account. The second criticism is that the simple moving aver-age gives equal weight to each day’s price. In a 10 day average, thelast day receives the same weight as the first day in the calcula-tion. Each day’s price is assigned a 10% weighting. In a 5 day aver-age, each day would have an equal 20% weighting. Some analystsbelieve that a heavier weighting should be given to the morerecent price action.
The Linearly Weighted Moving Average
In an attempt to correct the weighting problem, some analystsemploy a linearly weighted moving average. In this calculation, theclosing price of the 10th day (in the case of a 10 day average)would be multiplied by 10, the ninth day by nine, the eighth dayby eight, and so on. The greater weight is therefore given to themore recent closings. The total is then divided by the sum of themultipliers (55 in the case of the 10 day average: 10+9+8+...+ 1). However, the linearly weighted average still does not addressthe problem of including only the price action covered by thelength of the average itself.
The Exponentially SmoothedMoving Average
This type of average addresses both of the problems associatedwith the simple moving average. First, the exponentiallysmoothed average assigns a greater weight to the more recentdata. Therefore, it is a weighted moving average. But while itassigns lesser importance to past price data, it does include in itscalculation all of the data in the life of the instrument. In addi-tion, the user is able to adjust the weighting to give greater orlesser weight to the most recent day’s price. This is done byassigning a percentage value to the last day’s price, which is200 Chapter 9
added to a percentage of the previous day’s value. The sum ofboth percentage values adds up to 100. For example, the lastday’s price could be assigned a value of 10% (.10), which is addedto the previous day’s value of 90% (.90). That gives the last day10% of the total weighting. That would be the equivalent of a 20day average. By giving the last day’s price a smaller value of 5%(.05), lesser weight is given to the last day’s data and the averageis less sensitive. That would be the equivalent of a 40 day mov-ing average. (See Figure 9.2.)
 
(11/14/97 (*SPX) S&P 500 Stock Index
 
Daily Bar Chart
Simple vs. Exponential Averages
 
 
 
 
 
Figure 9.2 The 40 day exponential moving average (dotted line) is moresensitive than the simple arithmetic 40 day moving average (solid line).
The computer makes this all very easy for you. You justhave to choose the number of days you want in the moving aver-age—10, 20, 40, etc. Then select the type of average you want—simple, weighted, or exponentially smoothed. You can also selectas many averages as you want—one, two, or three.Moving Averages 201
 
The Use of One Moving Average
The simple moving average is the one most commonly used bytechnicians, and is the one that we’ll be concentrating on. Sometraders use just one moving average to generate trend signals. Themoving average is plotted on the bar chart in its appropriate trad-ing day along with that day’s price action. When the closing pricemoves above the moving average, a buy signal is generated. A sellsignal is given when prices move below the moving average. Foradded confirmation, some technicians also like to see the movingaverage line itself turn in the direction of the price crossing. (SeeFigure 9.3.)
If a very short term average is employed (a 5 or 10 day), theaverage tracks prices very closely and several crossings occur. This
 
(INTC) Intel Corp
 
Daily Bar Chart
50 Day Average
 
 
 
 
 
 
 
Figure 9.3 Prices fell below the 50 day average during October (see leftcircle). The sell signal is stronger when the moving average also turns down(see left arrow). The buy signal during January was confirmed when the aver-age itself turned higher.202 Chapter 9
action can be either good or bad. The use of a very sensitive aver-age produces more trades (with higher commission costs) andresults in many false signals (whipsaws). If the average is too sen-sitive, some of the short term random price movement (or“noise”) activates bad trend signals.
While the shorter average generates more false signals, ithas the advantage of giving trend signals earlier in the move. Itstands to reason that the more sensitive the average, the earlierthe signals will be. So there is a tradeoff at work here. The trick isto find the average that is sensitive enough to generate early sig-nals, but insensitive enough to avoid most of the random “noise.”(See Figure 9.4.)
 
(INTC) Intel Corp
 
Daily Bar Chart
 
 
 
 
 
 
Figure 9.4 A shorter average gives earlier signals. The longer average isslower, but more reliable. The 10 day turned up first at the bottom. But italso gave a premature buy signal during November and an untimely sell sig-nal during February (see boxes).Moving Averages 203
 
Let’s carry the above comparison a step further. While thelonger average performs better while the trend remains inmotion, it “gives back” a lot more when the trend reverses. Thevery insensitivity of the longer average (the fact that it trailed thetrend from a greater distance), which kept it from getting tangledup in short term corrections during the trend, works against thetrader when the trend actually reverses. Therefore, we'll addanother corollary here: The longer averages work better as long asthe trend remains in force, but a shorter average is better whenthe trend is in the process of reversing.
it becomes clearer, therefore, that the use of one movingaverage alone has several disadvantages. It is usually more advan-tageous to employ two moving averages.
How to Use Two Averages toGenerate Signals
This technique is called the double crossover method. This meansthat a buy signal is produced when the shorter average crossesabove the longer. For example, two popular combinations are the5 and 20 day averages and the 10 and 50 day averages. In the for-mer, a buy signal occurs when the 5 day average crosses above the20, and a sell signal when the 5 day moves below the 20. In thelatter example, the 10 day crossing above the 50 signals anuptrend, and a downtrend takes place with the 10 slipping underthe 50. This technique of using two averages together lags themarket a bit more than the use of a single average but producesfewer whipsaws. (See Figures 9.5 and 9.6.)204 Chapter 9
 
(LI0S98) Crude Oil, Light 05/98
 
Daily Bar Chart
 
 
 
 
 
 
Figure 9.5 The double crossover method uses two moving averages. The5 and 20 day combination is popular with futures traders. The 5 day fellbelow the 20 day during October (see circle) and caught the entire downtrendin crude oil prices.
The Use of Three Averages, or the TripleCrossover Method
That brings us to the triple crossover method. The most widelyused triple crossover system is the popular 4-9-18-day movingaverage combination. The 4-9-18 method is used mainly infutures trading. This concept was first mentioned by R.C. Allenin his 1972 book, How to Build a Fortune in Commodities andagain later in a 1974 work by the same author, How to Use the 4-Day, 9-Day and 18-Day Moving Averages to Earn Larger Profits fromCommodities. The 4-9-18-day system is a variation on the 5, 10,and 20 day moving average numbers, which are widely used incommodity circles. Many commercial chart services publish the4-9-18-day moving averages. (Many charting software packagesuse the 4-9-18-day combination as their default values whenplotting three averages.)Moving Averages 205
 
(INTC) Intel Corp
 
Daily Bar Chart
 
 
 
 
 
Figure 9.6 Stock traders use 10 and 50 day moving averages. The 10 dayfell below the SO day in October (left circle), giving a timely sell signal. Thebullish crossover in the other direction took place during January (lower circle).
How to Use the 4-9-18-Day MovingAverage System
It’s already been explained that the shorter the moving average,the closer it follows the price trend. It stands to reason then thatthe shortest of the three averages—the 4 day—will follow thetrend most closely, followed by the 9 day and then the 18. In anuptrend, therefore, the proper alignment would be for the 4 dayaverage to be above the 9 day, which is above the 18 day average.In a downtrend, the order is reversed and the alignment is exact-ly the opposite. That is, the 4 day would be the lowest, followedby the 9 day and then the 18 day average. (See Figures 9.7a-b.)
A buying alert takes place in a downtrend when the 4 daycrosses above both the 9 and the 18. A confirmed buy signaloccurs when the 9 day then crosses above the 18. This places the206 Chapter 9
 
10/15/97 (J¥0398) Japanese Yen 03/98
Daily Bar Chart
 
 
 
 
 
 
Figure 9.7a Futures traders like the 9 and 18 day moving average com-bination. A sell signal was given in late October (first circle) when the 9 dayfell below the 18. A buy signal was given in early 1998 when the 9 daycrossed back above the 18 day.
4 day over the 9 day which is over the 18 day. Some intermin-gling may occur during corrections or consolidations, but thegeneral uptrend remains intact. Some traders may take profitsduring the intermingling process and some may use it as a buy-ing opportunity. There is obviously a lot of room for flexibilityhere in applying the rules, depending on how aggressively onewants to trade.
When the uptrend reverses to the downside, the first thingthat should take place is that the shortest (and most sensitive)average—the 4 day—dips below the 9 day and the 18 day. This isonly a selling alert. Some traders, however, might use that initialcrossing as reason enough to begin liquidating long positions.Then, if the next longer average—the 9 day—drops below the 18day, a confirmed sell short signal is given.Moving Averages 207
 
(J¥0398) Japanese Yen 03/98
 
*, 48 Day Average
4 Day Average
Price Bars Have BeenRemoved for Clarity
 
 
 
 
‘Now Dec
 
Figure 9.7b The 4-9-18 day moving average combo is also popular withfutures traders. At a bottom, the 4 day (solid line) turns up first and crossesthe other two lines. Then the 9 day crosses over the 18 day (see circle), sig-naling a bottom.
MOVING AVERAGE ENVELOPES
The usefulness of a single moving average can be enhanced bysurrounding it with envelopes. Percentage envelopes can be used tohelp determine when a market has gotten overextended in eitherdirection. In other words, they tell us when prices have strayedtoo far from their moving average line. In order to do this, theenvelopes are placed at fixed percentages above and below theaverage. Shorter term traders, for example, often use 3%envelopes around a simple 21 day moving average. When pricesreach one of the envelopes (3% from the average), the short termtrend is considered to be overextended. For long range analysis,some possible combinations include 5% envelopes around a 10week average or a 10% envelope around a 40 week average. (SeeFigures 9.8a-b.) 
boev04/97 (¢DWIX) Dow Industrials
 
Daily Bar Chart
3% Envelope
Wer
21 Day Average3% Envelope
 
 
 
 
Figure 9.8a 3% envelopes placed around a 21 day moving average of theDow. Moves outside the envelopes suggest an overextended stock market.
 
2/29/95 (“DWI X) Dow Industrials
 
Weekly Bar Chart
5% Envelope
40 Week Average
 
 
 
 
 
Figure 9.8b — For longer range analysis, 5% envelopes can be placedaround a 10 week average. Moves outside the envelopes helped identify mar-ket extremes.Moving Averages 209
BOLLINGER BANDS
This technique was developed by John Bollinger. Two tradingbands are placed around a moving average similar to the enve-lope technique. Except that Bollinger Bands are placed two stan-dard deviations above and below the moving average, which isusually 20 days. Standard deviation is a statistical concept thatdescribes how prices are dispersed around an average value.Using two standard deviations ensures that 95% of the price datawill fall between the two trading bands. As a rule, prices are con-sidered to be overextended on the upside (overbought) whenthey touch the upper band. They are considered overextended onthe downside (oversold) when they touch the lower band. (SeeFigures 9.9a-b.)
 
(06/04/97 (DWI X) Dow Industrials
 
Daily Bar Chart
Bollinger Band
f"
VA1 N i
Bollinger Band
 
 
 
 
as a
 
Figure 9.9a Bollinger bands plotted around a 20 day moving average.During the sideways period from August to January, prices kept touching theouter bands. Once the uptrend resumed, prices traded between the upper bandand 20 day average.210 Chapter 9
 
5/24/96 (*DWI X) Dow Industrials
 
Weekly Bar Chart Bollinger Band
th |!
Iff
I 20 Week Average
Bollinger Band
 
 
 
 
 
 
Figure 9.9b Bollinger bands work on weekly charts as well, by using a20 week average as the middle line. Each touch of the lower band (see cir-cles) signaled an important market bottom and a buying opportunity.
USING BOLLINGER BANDSAS TARGETS
The simplest way to use Bollinger Bands is to use the upper andlower bands as price targets. In other words, if prices bounce offthe lower band and cross above the 20 day average, the upperband becomes the upper price target. A crossing below the 20 dayaverage would identify the lower band as the downside target. Ina strong uptrend, prices will usually fluctuate between the upperband and the 20 day average. In that case, a crossing below the 20day average warns of a trend reversal to the downside.Moving Averages 211
BAND WIDTHMEASURES VOLATILITY
Bollinger Bands differ from envelopes in one major way. Whereasthe envelopes stay a constant percentage width apart, BollingerBands expand and contract based on the last 20 days’ volatility.During a period of rising price volatility, the distance between thetwo bands will widen. Conversely, during a period of low marketvolatility, the distance between the two bands will contract. Thereis a tendency for the bands to alternate between expansion andcontraction. When the