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MOVING AVERAGES


RTH Risk/Reward Ratio Favorable

04/22/08 09:48:05 AM
by Alan R. Northam

The Retail HOLDRS is up against its 200-day moving average and downward sloping trendline. This is an ideal place to take a short position in this ETF, as the risk to reward ratio is highly favorable.

Security:   RTH
Position:   Sell

Figure 1 shows the daily price chart of the Retail HOLDRS. There is a high probability that RTH is now ready to turn lower, and here's why. First of all, the 50-day moving average crossed below its 200-day moving average in early September 2007, establishing RTH in a long-term downtrend. This long-term downtrend will remain in effect until proven otherwise. Second, we note that the downward-sloping trendline has been touched three times and has not been penetrated. The first touch came in mid-September 2007, the second touch came in mid-October 2007, and the third touch came in early April 2008. Third, RTH moved too far away from its 200-day moving average by January 2008 and has been in a corrective mode since. This three-month correction finally moved up to and bounced off the 200-day moving average and the downward trendline in early April and is now testing this moving average and trendline for a second time this month.

FIGURE 1: RTH, DAILY. This bar chart of Retail HOLDRS shows a 50-day simple moving average, a 200-day moving average, and a downward-sloping trendline.
Graphic provided by: StockCharts.com.
 
From a technician's point of view, a trend that is in motion stays in motion until proven otherwise. RTH is in an established downtrend. In addition, any move against the trend in motion is considered a countertrend correction. Thus, the rally from early January 2008 is considered to be a market correction. And finally, for the trend in motion to remain in motion, the downward-sloping trendline must not be violated. A move above this downward-sloping trendline will be the first sign that the downward trend is in the process of changing.

This is all fine and dandy, but how do you trade this ETF? From an educational standpoint, allow me to say that the current position of RTH is the perfect place to take a short position because the risk to reward ratio is extremely good at this point and the higher probability is that RTH will turn and move lower, as it is in an established downward trend. The risk comes from being wrong in taking a short position. However, with RTH up against its downward-sloping trendline, it wouldn't take much of a move higher to prove that the downward trend is reversing. So all that needs to be done in taking a short postion is to place a buy-stop just above the trendline to limit risk to a small loss in case RTH continues to move higher. However, should RTH bounce off the downward-sloping trendline, the reward is very good, as we can expect it to move to a new, lower price. To reduce risk further, a trader could wait one of two more days to make sure that RTH is going to turn back downw before placing a short trade. However, reducing risk by waiting also comes at somewhat reduced profit potential. Personally, I would wait to see if RTH was going to turn back down before taking a short position. Reducing a potential loss is a better money management plan than trying to maximize a potential gain.

Just remember that trading can result in loss of capital, and any decision to trade this exchange traded fund is your own.



Alan R. Northam

Alan Northam lives in the Dallas, Texas area and as an electronic engineer gave him an analytical mind from which he has developed a thorough knowledge of stock market technical analysis. His abilities to analyze the future direction of the stock market has allowed him to successfully trade of his own portfolio over the last 30 years. Mr. Northam is now retired and trading the stock market full time. You can reach him at inquiry@tradersclassroom.com or by visiting his website at http://www.tradersclassroom.com. You can also follow him on Twitter @TradersClassrm.

Garland, Tx
Website: www.tradersclassroom.com
E-mail address: inquiry@tradersclassroom.com

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