Tuesday, March 23, 2010

The 40-Week Moving Average Rule

This is a clip from a piece I wrote for the Canadian Securities Institute way back in April 2006

The 40-Week Rule:

The 40-week moving average (MA) is an industry standard for identifying trends. Keep in mid the 40-week on a weekly chart is the same as the 200-day on a daily chart. The rule is quite simple, if the PRICE is above the MA and the MA is pointed UPWARD, the trend is up. The trend is down if the PRICE is below the MA and the MA is pointed DOWNWARD.

I will also use the 40-week or 200-day MA to gage volatility and support levels.

Up trends and down trends in stocks can persist from several weeks to several years. A stock in an uptrend such as Dow component Boeing Co. will advance upward above its 40 week MA in a zigzag motion caused when it runs upward from the MA corrects down to the MA and then repeats the pattern over and over until the up trend comes to an end. Investors who are long the stock may reduce when the stock is “too far” above the MA and subsequently re-acquire the stock when it returns to support at the MA. New investors should never buy a stock when it is “too far” from the MA but rather enter when the stock returns to the MA. The problem is to define what “too far” is in terms on per cent.

What we are actually doing here is measuring volatility. I have found that volatility is normally higher in the micro-cap technology and resource stocks that typically trade under $5. It is not unusual for a copper or gold exploration company to trade up to 100% to 150% above the 40-week MA before a corrective period sets in.

A mid-cap industrial will rarely run above 50% above the 40-week MA and the larger caps will rarely run 20% above the 40 week MA and stock indices usually max out at the 10% level above the MA

To-day we will look for any stock that “returns to support at the MA” and fails to rebound by breaking down under the 40-week MA and possibly setting up a new down trend. A filter run last night at the close of March 22, 2010 selected over 25 issuers over the price of $3 that have just traded under their 40-week or 200-day MAs. To my surprise the list was populated by gold stocks. In other words we have a birds-of-a-feather sector failure. One example is Goldcorp a stock that is owned and loved by the BNN “experts” as set out on http://www.stockchase.com/Company-sl--slq-ID-slv-Goldcorp--Inc.php

One wonders if they all own and love Goldcorp, who is left to buy?


Prudent Man said...

Hi Bill, is there a rule of thumb for when a stock price that has been in an uptrend above the 40 WMA, then corrects and over shoots the 40 WMA to the downside and then reverses back above the 40 WMA. I'm finding that my stops placed below the 40WMA are getting triggered by a daily wide candle and then the stock settles back above the 40 WMA a few days later. Thanks

Gettingtechnical.com said...

Hello Prudent Man

OK so I assume the use of a simple 40w or 200d MA - now on a break under the MA I would not act for at least 10-days just to make sure it is not a false move. See if the stock will climb back and see of the MA is still pointed upward - a good example right now is PD.un just above the 40wma (7.24) over the next 10-days we will have either a sell or a buying opportunity

Prudent Man said...

Thanks Bill, coincidentally PD.un is the exact stock that I was stopped out at $7.45, with a small profit. I will now watch to see if it can get back up over the 200 DMA, and still sloping up over the next 10 days, and decide if to re-enter a position, with a sell stop just below the last recent low. One other question, would you ever use a 150 DMA or 30 WMA and if so when?

Trading Student said...

Hello Bill, is it better to use a 40 week simple moving average or exponential moving average when applying this rule? When I look at PD.UN with a 40 week simple moving average, it hasn't fallen below it and the up slope looks better. Thank you.

Gettingtechnical.com said...

Hello Guys

I think OK to use a 30 week as long as you stick to the strategy but do not do a flip-flop with a 30and then 40wma - we call that curve-fitting. On the simple and weighted issue a weighted MA is faster but will also deliver more false signals - Bill Carrigan