The Triple Moving Average System
The triple moving average crossover system is used to generate buy and sell signals. Its buy signals come early in the development of a trend, and its sell signals are generated early when a trend ends. The third moving average can be used in combination with the other two moving averages to confirm or deny the signals that they generate. It thereby reduces the chance that the investor will be acting on false signals..
The shorter the moving average, the more closely it follows the price trend. When a stock begins an uptrend, short-term moving averages will begin rising far earlier than longer-term moving averages. For example, if a stock declines by equal amounts each day for 50 days, and then begins to rise by the same amount each day for 50 days, the 5-day moving average will start to rise on the third day after the change in direction, the 10-day average will begin to rise on the sixth day after the change, and the 20-day average will begin to rise on the eleventh day. The longer a trend has persisted, the more likely it is to continue persisting, up to a point. Waiting too long to enter a trend can result in missing most of the gain. Entering the trend too early can mean entering on a false start and having to sell at a loss. Traders have addressed this problem by waiting for three moving averages to verify a trend by aligning in a certain way. To illustrate, we’ll use the 5-day, 10-day, and 20-day moving averages. When an uptrend begins, the 5-day moving average will start rising first. Traders view this as interesting but of no major significance. As the upside momentum increases, longer moving averages gradually begin to follow suit.
A buying alert takes place when the 5-day crosses above both the 10 and the 20. That is, the average price of the stock over the last five days is greater than its average over both the last ten days and the last twenty days. This shows a short-term shift in trend. A buy signal is confirmed when the 10-day then crosses above the 20-day. The 10-day average price of a stock is more meaningful than the 5-day average price. If the average price over the last ten days is greater than the average price over the last twenty days, the shift in momentum is considered to be much more significant. Conversely, when an uptrend changes to a downtrend, the first thing that happens is that the 5-day declines below the 10-day and 20-day averages. This constitutes an alert that a sell signal may be forthcoming. The confirmed sell signal occurs when the 10-day crosses below the 20-day resulting in an alignment in which the 5-day average is below the 10-day average and the 10-day average is below the 20-day average. More aggressive traders often use the alert crossover as the actual sell signal because it locks in more of the profit. However, the risk of doing this is that the stock may only be "catching its breath" before continuing its advance. The confirmed sell signal could then take place at a much higher price. Therefore most traders consider the sell signal to be generated by the 10-day crossing below the 20-day.
I recommend using the 5-day moving average as a filter for each crossover event. That is, alignment can be used as a tool to reduce whipsaws. For a buy signal, the appropriate alignment is for the 5-day average to be above the 10-day, and for the 10-day to be above the 20-day. For a sell signal, the 5-day would be below the 10-day and the 10-day below the 20-day. If the 10-day has just given a buy signal by crossing above the 20-day average, a trader might abstain from making the purchase if the 5-day is now declining or below the 10-day average. The purchase would be made only if the 5-day resumes its ascent or is above the 10-day average while the 10-day average is still above the 20-day average. If the 10-day average gives a sell signal by crossing below the 20-day average, the trader might abstain from selling if the 5-day average has turned and is now rising, or if it is now above the 10-day average rather than below it. The sale would be made only if the 5-day resumes its decline or falls below the 10-day average while the 10-day average is still below the 20-day average. Our stockdisciplines.com traders have learned through experience that using the 5-day average in this way can dramatically reduce whipsaws (untimely and unnecessary buying and selling). The reason these alignments are important is because the shorter moving average is extremely sensitive to the development of a counter-trend in the stock’s price. If a trend counter to the trend indicated by the crossover of your major moving averages is developing, it makes sense to wait for that counter-trend to dissipate before taking action.
Investors and traders might be wise to incorporate another indicator into their decision-making. To increase the reliability of the signals given by the system outlined above, it might be wise to use the 50-day moving average as a context and reference. The best and most profitable time to buy a stock is early in a new trend. Later buy signals carry greater risk that the stock will soon decline (because stocks don’t go up forever). Therefore, if the 50-day average has been in a significant decline and is now leveling off or just beginning to rise, a buy signal using the triple crossover method outlined above has a greater chance of success than if the 50-day average has been rising for a long time, or is beginning to level off or decline after a prolonged advance. In other words, the intermediate-term 50-day average can be used to confirm and "support" the signals given by the shorter-term moving averages. Generally, it’s better to avoid buying a stock if its 50-day moving average is in decline. A short-term trader might make an exception to this general policy in order to profit from a snap-back toward the declining 50-day average from an extreme oversold condition. When a stock is not trending (when it’s going sideways) the moving averages will intermingle and repeatedly crisscross each other. Here, the actual crossovers become worthless as buy or sell signals. However, the condition represents either consolidation or distribution. Thus, traders may look at these times as foundations for good entry or exit points, depending upon their conclusions about what the stock is most likely to do next or on specific breakout behavior. Various chart configurations (rising triangles, flags, etc.) can give clues about the stock’s probable behavior once it begins to move again. The reader can also get hints about a stock’s inclination by observing whether the volume increases or decreases when the stock’s price rises or falls. For example, if volume increases on down days and declines on up days, the stock is announcing its determination to go down, and so on. The volume gives clues about the direction of stock movement to which money is being committed. Finally, the trader can simply wait for the stock to "show its hand" by breaking through support on the downside or through overhead resistance on the upside. In either event, the move is not very trustworthy without a significant increase in volume.
Dr. Winton Felt maintains a variety of free tutorials, stock alerts, and scanner results at www.stockdisciplines.com has a market review page at www.stockdisciplines.com/market-review has information and illustrations pertaining to pre-surge "setups" at www.stockdisciplines.com/stock-alerts and information and videos about volatility-adjusted stop losses at www.stockdisciplines.com/stop-losses