End of Shortened Trading Week
Market Overview
An inside candle marks the end of this shortened trading week. We did not exceed the open or close of last week. Last week, the price tested the $450 resistance line. This week, the price failed to move about the resistance line. Volume was also down this week compared to last, which is unsurprising considering the shortened week. But it still reflects less investor engagement this week. This low volume, coupled with an inside candle, does not give much insight into the expectations for next week.
Looking at the RSI and short-term MACD on the daily chart, we see they are sitting near their respective middles. Both returning to the center after a shortlived upward movement. The long-term MACD is near the overbought line but is gently sloping down. Price is sitting between the 21 and 50-day EMA on the daily chart. Again, not much to be gleaned from this week.
Sector breadth is showing weakness. Technology and Energy are remaining as notable holdouts. So far this year, Technology has led the rally. Last year, during the bear market, Energy held its own.
Utilities remain the poor performer this year.
The weak relative sector performances encourage the embrace of negative news quickly. The SP500 cannot do well if its underlying sectors are not participating.
Research Corner
What is a Moving Average
Moving averages are a standard tool for determining trends. Simply put, they take the average of consistent values (high, low, close, etc.) over a predetermined time. The most common value used to calculate a moving average is the close. Generally, the close is accepted as the “true” price for the observed period. The two main ways to calculate moving averages for trading and trend analysis are simple (SMA or MA) and exponential (EMA).
Simple is calculated as a standard arithmetic mean, with all the values added and then divided by the number of values. This method of calculation suffers from something called the dropoff effect. This effect is when a large value is dropped from the average calculation, producing a significant shift in the average value.
Exponential moving averages are calculated in a manner that avoids the dropoff effect. EMA’s are calculated by weighting the previous EMA value against the new value that is added. To calculate the weight of the new EMA value, we use the smoothing factor divided by one plus the number of periods. The most common smoothing factor is two and is what I will use for the example:
Weight = 2 / (# of periods + 1).
Thus, the formula for the new EMA value is:
EMA = Previous EMA * (1 - Weight) + Current Value * Weight
This method of calculating the moving average takes all past values into account.
Below is a chart showing an EMA and SMA of the same period. As you can see, they are close, but there are some notable differences. The EMA tends to follow the price action more closely.
Basic Moving Average Signals
Moving averages are generally used by combining two moving averages of different lengths to get trading signals. A standard signal is to buy when the fast (short length) moving average crosses over the slow (longer length) moving average and go short when the fast crosses under the slow.
Another use of the moving average is as a trailing stop loss. For example, when you enter long into a position, you maintain the position until the price touches or closes below a predetermined moving average. You would exit the position for shorts when the price touches or closes above the moving average.
Limits of Moving Averages
Moving averages are a lagging indicator. They are calculated using historical price information and do not have a predictive component to their equation. They also struggle to display the trend in a sideways or consolidating market accurately. As with any indicator or financial analysis tool, they should not be used in isolation.
Next Week: Advanced moving average signals and techniques