Hi Folks,
I just wanted to build a step by step educational guide on some simple tools and indicators that I use to help anticipate market reversals!
I figured this was a great time to do it considering the market events last week and touching on how as a short term trader this could have been navigated!
Lets start with moving averages! This is a very common question I get asked frequently.
What moving averages do I use and what do they mean to me and my trading strategies?
First, what is the basic definition of a moving average? A moving average simply tracks the price of a stock over a chosen period of time. Using the time period the data is continuously updated by dropping the oldest data set and replacing it with the newest data set (The stock price)
The two most commonly used types of moving averages are the Simple Moving Average (SMA) and the Exponential Moving Average (EMA).
The Simple Moving Average (SMA): Is a technical indicator that shows the average price of a stock over a set period of time. It's calculated by adding up the prices of a security over a period of time and dividing the total by the number of periods. The average is plotted on a chart as a line that moves along as the average changes. The plotted line represents a trend over the period of time.
The Exponential Moving Average (EMA): Is a technical indicator that shows the average price of a stock over a set period of time. The difference between a SMA and an EMA lies on how the indicator is calculated. An EMA puts greater emphasis on the most recent price data. Where as an SMA is equal weight across the entire period.
Both the SMA and EMA help traders identify and follow trends in price. Often the use of a SMA or EMA comes down preference but from a timeframe point of view an SMA usually works best over longer period of times and an EMA shorter time frames.
Moving averages are an important tool for trend identification and identifying the general strength and health of a trend. If price consistency closes above a short term moving average the trend and strength of the stock could be considered strong. If that same moving average begins to be tested and the stock starts closing below the moving average without reclaiming it then the trend could be considered under pressure, weakening or in stages of a failure or a correction period.
What Moving Averages do I typically use?: On a daily timeframe chart I like to use the 20 EMA to track strong short term trends and the 50 SMA to track short to medium term trends.
Its typical for a strong, bullish market on a daily timeframe chart to extend above a trending moving average (20 EMA) and then fade from the extension over a 3 - 5 day period to retest the moving average price. The market may "Ping - Pong" up against the moving average for an additional 3 - 5 days before resuming the trend higher (continuation).
Here is an example of how that sort of trend can develop and trade against a 20 EMA!
With this information on hand you can develop a trading and portfolio allocation strategy. In the most basic of terms when the market is trending and trading above the 20 EMA in a bullish manner your positioning may be 3 - 4 concentrated positions such as a leveraged ETF, and 2 - 3 stocks from the strongest sectors. As the market build momentum and starts to extend above the 20 EMA you slowly reduce sizing and book profits in anticipation for a short term pullback. When the market pulls back you add back into full size and continue with the trend.
The "Holy Grail" setup can be useful for this type of trend following strategy. At minimum it can be a good indication as to when to put size on or add back into a trade.
Read more about that here - Click the photo to open a new link on the topic!
Ok, but sometimes the market goes through pullback phases that last much longer than 3 - 5 days! For example the corrective phase that occurred in July 2024! How do I handle and anticipate multiple weeks of weakness?
You may have heard the term "The trend is your friend" used from time to time. If you're objectively looking at a stock chart without bias it is an excellent visual indicator of where or where you shouldn't be in the market.
A gap down below a major trend line that the market doesn't attempt to buy back up is a good indicator of a potential change in trend. If the stock remains below the trendline for multiple days with no real attempt at a bounce chances are the stock or the index is transitioning into a corrective phase that could last 2 - 4 weeks or more.
Your second line of indication is the 50 SMA. This moving average is a short to medium term trend follower. If the stock or index begins to fail below the 50 SMA a larger correction may be on the horizon. A circumstance where this wouldn't apply is if the market or stock rapidly corrected of a very short period of time (Think 3 days) and on the day it tested and traded below the 50 SMA it ended up reclaiming it and closing it a bullish manner, like a hammer candle that reclaimed the low from the day before!
Lets review how a trend can end and change and what can set that change up!
The defined trendline begins to fail and the stock fails to hold above the 20 EMA.
Usually this plays out over a 3 - 5 days period. Its the first sign. The stock or index makes an attempt at a bounce but fails and stays below the moving average.
Weakness continues and the 50 SMA fails to hold. Again it isn't unusual to see a 3 - 5 day period play out where the stock or index meanders in a range without making any meaningful progress. Often the moving average becomes a new point of resistance.
The market breaks down in a dramatic quick fashion. This quick breakdown is often met with higher than average volume, a spiking VIX and all out negative sentiment where ever you look.
A short term trader needs to get out of the way of markets like this. Experienced traders will look for spots to short but that needs to be just as calculated. Capital preservation should be your number one goal. Getting caught against a corrective phase can wipe out mental and emotional capital not allowing you to prefer for the next opportunity! This is where traders make mistakes, revenge trade, over trade which results in losses far greater than they expect and often far greater than they can handle.
The second condition a trader might encounter is where the market looks poised for a breakdown but instead of breaking down lower it tests a moving average and rallies higher back off of it. This usually happens when the trend is coming off of a very strong period. The market will make a dramatic move lower in a very short period of time 1 - 2 days. Test a moving average and bounce straight back off of it with power. Similar to what happened to $QQQ on December 20th, 2024. Again when the ETF tested the 50 SMA, broke below it and managed to close back above it on January 2nd. Leading to a recovery attempt on January 3rd. $QQQ $505 becomes the point of risk going forward where a break below could create a bigger event like in July 2024 or smaller and similar to August into September.
Capital preservation is the key concept when markets correct. Be patient.
Ok, so now that I know how to anticipate a change in trend in the market are there ways to capitalize when the market becomes "oversold" or when sentiment becomes all out bearish and panic like?
I like to utilize NYMO / NAMO. The NYSE Mcclellan oscillator and the Nasdaq Mcclellan oscillator. I have found this to be a very reliable indicator over the years and I keep it on my watchlist because of this.
Basically on average you will get 2 - 3 NYMO / NAMO extreme oversold readings per year. It signals at least a temporary bottom in the market and is usually good for a strong bounce that lasts 3 - 4 days after the signal. Experienced traders will put on leveraged ETFs to take advantage of these dramatic short term moves.
As a matter of fact NYMO and NAMO signaled an oversold condition on December 19th. This followed a strong 4 day rally higher from there. The previous oversold signals were around April 19th and August 5th of this year. Looking back at those dates you can see how precise the oscillator was at signaling a bottom and subsequently a reversal in the market higher.
I was guiding Art of Trading private members through this observation on December 19th and followed up on it as it progressed. This is something we often take advantage of when it presents itself.
After the subsequent bounce played out in the market December 20th into the 26th the market pulled back again, this time making a new low. NYMO / NAMO followed with a higher low creating a bullish divergence. The index holding above the 50 SMA and trying to reclaim the 20 EMA could help solidify another run higher for the market. Risk is measured off of the low made on January 2nd.
Study these NYMO and NAMO charts from covering the past 2 years and note the amount of times the oscillator crossed the extreme oversold threshold (Horizontal lower line). Put these dates up against a Nasdaq chart or QQQ and study the price action that followed!
NYMO:
NAMO:
You can find my NYMO and NAMO charts on the first page of my public watchlist!
Read a step by step guide on NYMO and NAMO here:
I think these moving averages and tools will become very useful in 2025. We're sure to see some strong trends both higher and lower. As a trader its your job to get in and out and opportune times to book, preserve and take advantage of capital building opportunities.
Create strategies that mesh well with your current skillset and trading style within the market!
Cheers and happy trading!
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