Take a look at this ETSY chart. At first glance, it looks like a disaster. Take a closer, 2nd look. Really look at the trend lines. Individually, do they all make sense? At least in hindsight?
In my opinion, the answer is yes. Without a doubt, they all make sense individually. Or at least you can make a case for each trend line.
But collectively, how are you supposed to trade off of this chart?
What is the trend? Where is the support and resistance?
What does this chart look like to you? From a distant.
Probably, what you thought at first glance. A mess. “This trader clearly has no idea what he is doing.”
This is my problem with trend lines. They are subjective. I can make the most bearish chart look bullish and the most bullish chart look bearish.
Here are a few examples:
AAPL has been making higher highs and lower lows from July 2020 through December 2021. There’s no doubt about it.
Now let’s make this chart look bearish..
Support broken and target levels planned! Short trade is on.
Now let’s make this chart look bullish again.
We have a buy the dip opportunity on a strong uptrending stock. Plus, it’s AAPL, one of the best companies in the world. Great companies are more likely to go up than down. This provides a great R:R.
Do you see my point?
Hell, while annotating both of these charts, I first convinced myself on a short. Then I convinced myself to go long!
Now, neither of these are wrong. They are just drawn different. With a proper plan (Stop loss, targets, position sizing) either of these trades can work. Only time will tell.
But we want to to increase our odds of a trade working for us, not against us.
This is where moving averages come into play.
Most of you know what moving averages are. For those that don’t: moving averages are a smooth line of the average price for the past X days of a stock.
Many traders use moving averages in different ways. Some will buy and sell if price moves above or below a specific moving average, such as the 20-day simple moving average.
I believe moving averages are best used as OBJECTIVE, dynamic trend lines.
I just showed how trend lines can be drawn hundreds of different ways to support your bias. Because they are SUBJECTIVE.
Let’s look back at AAPL with moving averages shown.
The moving averages shown are EMAs. EMAs are….. They EMAs shown are the 8,13, 21, 34, and 55-day exponential moving averages. Notice how the EMAs are in numerical order. Meaning the 8 > 13 > 21 > 34 > 55. This signals a strong uptrend on the daily chart.
Think about it. The average price for the past 8 days is higher than the average price for the past 13 days which is higher than the average price for the past 21 days and so on.
Price is objectively in a strong uptrend. The unbiased odds are that price is going to continue to RISE. Does that mean that a short cannot work as shown previously?
No, and actually that setup looks pretty good for a short, especially considering the current state of the market (Unknown to you reading this right now).
Regardless, we are in a game of increasing our odds. Therefore, I do not like to short uptrending stocks. If you are looking for shorts, why not find a stock that is in an established downtrend or is on the cusp of starting a downtrend.
See SQ below.
Now which stocks do you think gives you the best chance of decreasing in price? I don’t know about you, but my BET is on SQ.
That doesn’t mean it will happen, but it gives us the best chance of it happening.
This works because of human psychology which you will learn in the next lesson.
In conclusion. MAs act as dynamic trend lines which objectively determine the trend of price direction. In an uptrend, MAs act as support, and in a downtrend, MAs act as resistance.
