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Market Direction And Trading Longer-Term Moving Averages

Sep 5, 2012 | Profit And Income Strategies, Stock Market Outlook

Market Direction over the past few days remains choppy at best and despite analysts best guesses no one can actually predict with any degree of certainty whether the stock market direction is putting in a second top here or can break free and move considerably higher. I have often said that market direction is the most important aspect of trading options but often it’s tough to know the overall market direction with any degree of certainty.

Even if the market direction should pick up and push higher, there is no guarantee that the stock market will break out to all time new highs. Indeed any move higher from here could be simply a last-ditch effort by the bulls which ends up in a market top being put in place. My market timing indicators can only look out a few days at best. Instead for longer-term market direction I like to rely on the simple strategy of using the 50 day, 100 day and 200 day moving averages.

Market Direction and Long Term Indicators

Long-term market direction indicators that are the most reliable are usually the 50 day, 100 day and 200 day moving averages. It really does not matter whether using exponential moving averages or simple moving averages when trying to determine long-term market direction. In the chart below I have selected the 50 day simple moving average which is blue, the 100 day exponential moving average which is yellow and the 200 day exponential moving average which is purple.

Moving Averages Trading

Using these three moving averages can assist when trading options as an investment strategy. Let’s review the six month S&P 500 chart below to see what we should be looking at when it comes to trading options against moving averages. I have marked the important points by numbers and by letters. I describe below what each indicator is referring to and what should be looked at. The dates of each important point does not matter. The S&P 500 readings also do not matter. What is important is the moving averages and what they are showing throughout the 6 months.

Market Direction based on moving averages

Using the 50 day, 100 day and 200 day moving averages can assist in watching long-term market direction.

1. The S&P 500 market direction turned down and crossed the 50 day moving average. This is a signal warning and nothing more. You can see that prior to point 1, there were several times when the 50 day moving average was violated but each time the S&P market direction turned back up. So when the 50 day moving average is violated this is not a clear signal that the market direction is going to pull back. Instead it is a warning. Therefore when the 50 day moving average is violated I usually pull back on selling puts to see if the moving averages will recover. If they recover then I go back to selling more puts on my favorite stocks.

Remember that almost all stocks will follow market direction. I am never worried when the 50 day is violated but I use it to tell me when to pull back on committing additional capital to my Put Selling. So, violating 50 day means hold back on selling more puts.

2. The 100 day moving average is violated. When this happened almost always the market direction will continue to be under pressure. Normally I then look to see if I can sell naked calls out of the money for decent premiums. I know when trading options that a violation of the 100 day moving average will mean the market direction will stay down for a few trading sessions and I can normally lock in some profits through selling out of the money naked calls.

3. The 200 day moving average is violated. Despite everything you may read, the 200 day moving average is still an excellent timing tool to advise when an investor should become defensive. When the 200 day moving average is violated put premiums will jump in value as the market maker will move premiums higher on puts. This is because the market maker knows many longer term investors will want to buy some put protection.

When the 200 day is violated then I immediately look for out of the money puts on my favorite stocks that have put premiums, fatter than usual. I can then sell those premiums for better profits than when the 50 day or 100 day moving averages are violated. This is why I sell options only against stocks I would own. I am Put Selling when the market direction is violating the 200 day moving average. A break of the 200 day moving average could mean a drop in the overall market direction is about to occur. If you look at the 10 year chart below you can see what I mean. Market direction can plunge if the 200 day moving average is broken. While I am busy enjoying fast put premiums when the 200 day is violated, I am also keenly aware that market direction could fall a lot further once the 200 day moving average breaks. For investors who sell against juniors or speculative stocks, a break in the 200 day is a sure sign to be careful Put Selling those kinds of stocks. For me however, the market direction break of the 200 day means I can sell against my favorite stocks at out of the money put strikes where I would love to own them. A break of the 200 day is for my option investment method, a terrific opportunity not to be missed.

The chart below shows that the 200 day moving average remains an excellent means to determine long-term market direction. The 200 day moving average strategy kept investors out of most of the carnage of the last two severe bear markets.

10 Year Chart Of Market Direction

The 10 Year Chart of S&P 500 Market Direction shows that the 200 day moving average remains an excellent long-term indicator.

4. The 200 day moving average is again breached and the market direction continues higher. I move to close any naked calls that I have sold and commit more capital to selling puts as I try to earn as much income as I can while put premiums are still high.

5. The 100 day moving average is breached as the market direction continued higher. By now I have most of my capital at work and I will be looking to buy to close naked puts that are trading for pennies.

6. The 50 day moving average is breached as the market direction pushes back to try to regain lost ground. By now many naked puts which I sold when the 200 day moving average was broken have been closed for pennies.

7. The market direction plunges back as the move above the 50 day moving average at point 6 cannot be held. The 50 day moving average and 100 day moving average are both violated on the same day. While the 50 day is a warning, the 100 day violation tells me the market direction should fall lower before it can turn back up. While the 50 day advises not to sell many puts but to watch for any further erosion of market direction, the 100 day violation means start selling out of the money puts and look for out of the money calls that are worth selling.

8. The 200 day is violated once again. Time to sell more puts for bigger premiums as explained in number 3 above.

Following number 8 you can see that the market direction turned back up again. I normally follow the same steps as the moving averages are breached to the upside.

POINT A. I have marked A as the 50 day crossed the 100 day. I normally watch at this point to see if the 50 day will break the 200 day. If it does break then almost always the market direction will move solidly lower than previous market lows. Instead as you can see the market direction turned lower, but at 9 and at 10 the market direction failed to break the 200 day moving average.

Longer-term Market Direction Indication From 200 Day Moving Average

Note how as point A is reached the 200 day moving average begins to climb. As the 200 day is not breached at point 9 and 10 but instead market direction bounces off the 200 day and moved higher, the 200 day is already climbing. The climb in the 200 day is a signal that the overall trend of the market direction is higher. If you look closely at the chart you can see that when the S&P 500 made its low at the start of June but failed to fall lower, the 200 day which had just started to turn lower, reversed trend and began to climb. This was the clue that I wrote about numerous times starting in early June in my market direction outlook articles pointing to the higher highs and higher lows. The 200 day has continued to climb and at POINT B, the 50 day crossed back up over the 100 day moving average and has been climbing since then. The 50 day never crossed the 200 day. This means that the market direction up remains intact longer-term. I then went back to committing more capital to put selling which is part of the reason I have sold so many puts on stocks like Intel Stock and YUM Stock along with others.

The 200 day is well worth watching. I realize that many market pundits, analysts and blogs write constantly how the 200 day moving average is no longer a reliable indicator. All I can say is everyone is entitled to an opinion. My opinion is that the 200 day moving average is an excellent long-term indicator. It will never get investors out at a market top, or get investors in at a market bottom. That is impossible for the 200 day to identify. But it was never meant to time tops and bottoms, but instead it is used to capture most of the trend up and to get investors out in case the market direction is going to turn much worse.

POINT C – Moving Averages Trading

This brings me to point C. At point C the 200 day moving average is still climbing. Therefore while the 200 day moving average cannot pinpoint a market top or even warn that a market top is being put in place, the climbing of the 200 day is a great sign that the market direction presently still remains higher.

Once the 200 day flattens out and if it turns down, then watch for the 50 day to fall. If the market direction changes and violates the 50 day I will be pulling back on selling options, both naked puts and naked calls, until I see if the 50 day crosses the 100 day as it has previously done.

If that happens then the market direction could indeed be putting in a new top and the trend could be lower.

When To Consider Buying Market Direction Puts

With the S&P 500 trying to break past the April market highs, but overall earnings not supporting continued market highs, any downturn in the 50 day back over the 100 day would certainly warrant my considering buying SPY PUT options again. When markets are as high as the present market is, a pullback could easily be 10%. That 10% could spook a lot of investors and selling might increase. This could push a market decline beyond 10% making market put options extremely profitable.

Market Tops Are Profitable

Market tops can be incredibly profitable when they “top out”. While I believe buying puts as the market wanders like it is presently doing, is basically gambling, I do believe if the 50 day is violated, buying market puts is warranted and I will definitely be buying at that point. I will not be buying market puts yet as I do not see anything that tells me the 50 day could be violated yet.

Market Direction And Using The Moving Averages Summary

You can see from this article that spotting market direction tops is not an easy thing to do. But if an investor follows this simple strategy of following moving averages when trading options, it really isn’t necessary to know when a market top is in place anyway. The investor who follows the 50 day, 100 day and 200 day moving averages strategy can benefit through Put Selling and selling Naked Calls at opportune moments based on the moving averages strategy.

This simple strategy of using moving averages can assist those of us who trade options as a principal investment method. While what I have shown is being used for the selling of put and call options, it can easily be reversed for buying puts and calls for market direction movements. Not only can this simple strategy create decent profits, but it also allows an investor interested in options trading to preserve his capital for those moments will committing it for large profits makes sense.

Trading the moving averages as I have described, is a simple strategy that I have used for decades and sometimes simple is all an investor needs in order to profit from the overall market direction.

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