All price trends eventually end. That’s been true since stocks began trading centuries ago. And it’s likely to be the case for centuries to come.
New traders are quick to forget this time-tested truth. For many, their first experience with trends happens during a bull market.
Here’s how it usually goes…
A bull market begins, and people hear about others making money. Thinking they’re smarter and not wanting to miss out, they jump right in. Initial success tells them to keep buying more and more.
Then suddenly, the uptrend ends. It always seems abrupt. Losses mount as new traders realize that they aren’t really smarter than the market.
Experienced traders, however, understand that downtrends always follow uptrends. They also know that all trend reversals follow the same basic pattern: Prices first fall below a short-term moving average (MA).
And now’s not the time to look away, because this particular MA recently signaled a big warning for the market.
Moving Averages: Your Road Signs for What’s Ahead
A MA basically shows the direction of the trend (be it up, down or sideways). When prices are above the MA, the trend is up. But when prices are below it, the trend is down.
Traders generally follow several MAs to define different trends. Here are three important ones to keep in mind:
- The five-day MA defines a short-term trend (usually a period of one to three months).
- The 50-day MA defines an intermediate-term trend (about three to six months).
- The 200-day MA determines the direction of the long-term trend (a year or more).
Closely following MAs is critical to catching signs of a reversal.
Bear markets begin with a drop below the five-day MA. Then prices close below the 50-day MA on their way down. By the time the price crosses below the 200-day MA, traders have significant losses.
As you can see in the chart below, the SPDR Dow Jones Industrial Average ETF (NYSE: DIA) fell below its 50-day MA this week.
This is a warning sign I’m not willing to ignore, and neither should you.
The last bear market in February 2020 began with a break of the 50-day MA. Traders who turned bearish then would have enjoyed large profits.
Navigating Trends Wisely
Of course, false signals can make it tricky. Since the bull market began in March 2020, the DIA dipped below its 50-day MA three times. Rather than falling lower, the uptrend quickly resumed each time. Acting on the sell signal would have resulted in a small loss or gain on those signals.
Alternatively, many traders prefer to wait for prices to fall below the 200-day MA (dashed line in the chart) before making any moves. The drawback to this approach is that it results in larger losses after the trend reverses.
With where the DIA is priced at now, it will require a drop of more than 10% to reach that 200-day MA level. And just like the 50-day MA, the 200-day MA also suffers from some false alarms that are closed with small losses or gains.
The chart also reveals that MA buy signals come long after the uptrend begins, thereby stunting gains. This is a reason some traders ignore MAs altogether. I think that’s rather unwise.
MAs Help Keep Your Portfolio From Bleeding Out Profits
Instead of passing up MAs completely, traders can add another tool to their strategy that’s better at pinpointing buy signals. No point in tossing a useful indicator out the window simply because it can’t do it all. Each technical tool has a specific use, and MAs are best used to manage risk. They work better for spotting timely sell signals to cut losses.
While no MA is perfect, using any of them can help us avoid large losses simply by alarming us when it’s time to turn cautious, or even bearish.
Now that we’ve seen the break of the 50-day MA, we could very well be staring at the tip of the next bear market. The DIA is signaling that it may be time to switch to put options. Even if the trend quickly reverses, well-selected puts could still deliver gains.
There’s really no shortage of profit-snatching opportunities if you know where to look and when to strike. That said, keep watch for new timely ideas and insights on trading options from True Options Masters each day. There’s more to come.
Michael Carr, CMT, CFTe
Editor, One Trade