EMA Ratio Extremes Reversal Warnings

10/21/09 08:55:55 AM

by Donald W. Pendergast, Jr.

Sometimes, you stumble across a technical analysis technique that almost seems too good to be true. Here's a look at a simple (but true) technique that savvy traders may be able to use to their advantage.

Security: GDX
Position: N/A

If you've been trading for any length of time, you may have heard the trader's expression "Top- and bottom-pickers become cotton-pickers." And if you've ever tried to call a market top or bottom, then you already realize how true that statement can be, as a trend in motion can move farther and faster than you could ever anticipate. That said, there are a variety of statistical tools available that can at least warn of the likelihood of a reversal within a certain window of time. If the reversal happens as planned, then you can use other tools to implement a countertrend trade that has a good chance at success. Let's take a look at one such method right now.

FIGURE 1: GDX, DAILY. When stocks, ETFs, and futures contracts move up too far, too fast, the use of a 12/50 EMA percentage spread and negative price-momentum divergence can help time profitable short-term countertrade trades.

Graphic provided by: MetaStock.

Graphic provided by: WB Detrend EOD from ProfitTrader for MetaStock.

Figure 1 is a daily chart for the Market Vectors Gold Miners exchange traded fund (ETF)(GDX) that spans the months since the major low was made in this precious metals ETF. On the chart, the 21- and 50-day EMAs have been plotted. At the top of the chart is a custom indicator called the EmaRat, one designed to measure the spread between the 12- and 50-period EMAs. You'll also note the two red horizontal lines that are plotted on top of the indicator itself; the lower one is set to 1 to 1, equal to the crossover point of the two EMAs. Just above that, the other red line is set at 1.1 to 1. If the indicator goes this high, it simply means that the 12-period EMA has a value that's 10% greater than the 50-period EMA. If you look at the chart, you'll note that whenever the spread between the two EMAs gets extreme (greater than 10%), a significant (and usually tradable) reversal occurs, sometimes taking prices back down to the 21-period EMA and sometimes all the way back down to the 50-period EMA. In addition, by using the detrend oscillator, you can also determine if a negative price-momentum divergence is already in place when the spread between the two EMAs is equal to and/or exceeds 10%.

The three shaded areas on the chart depict what happened in the recent past each time the EMA spread hit 10% or more and a detrend negative divergence was already confirmed. Take a good long look at this simple technical setup; it really does work, and on a variety of stocks and futures contracts, too. Of course, a trader must always remember that in most cases, these are countertrend trade setups and they need to be able to enter and exit quickly as conditions change. The only time they would not be considered countertrend is when the next higher time frame (in this case, the weekly chart) is also in a similar EMA spread extreme. If that's the case, your chances of success are enhanced by a significant degree, as the downdraft in the weekly time frame will invariably drag prices lower on the daily time frame as well.

To review, let's lay this out in a step-by-step manner for greater clarity:

* Determine that the market has already made a major low.

* Note the EMA spread extremes attained on the rise up from the major low. In this case, it was obvious that 1.10 was the key spread figure at which to expect a reversal to occur. Even if you miss the first major reversal, don't sweat it; just wait for the subsequent extreme spread reading to print (in this case, it was in February 2009). Since the most extreme reading will normally be seen on the first major thrust up from the major low, this is an excellent tactic — that is, waiting for the second extreme peak to print.

* Once you're satisfied that an extreme has been reached (over 1.10 in most stocks and ETFs on a daily chart), confirm that the detrend oscillator is confirming a negative price-momentum divergence.

* With all of the above already in place, wait for the EmaRat (short for EMA ratio) spread to drop after a reading of at least 1.10 is attained and then enter a short position at the next session's open. Set an initial stop-loss just above the recent swing high and let the trade rip. Your first price target is the 21-period EMA (green EMA line on the chart) and the second target is the 50-period EMA line. If prices cooperate and begin to fall after initial entry, run a three-bar trailing stop of the highs, tightening it to a two-bar trailing stop of the highs should the first price target be reached. If you are fortunate enough to make it all the way down to the 50-period EMA, close out the entire trade, book a profit, and run for the hills, because the 50-period EMA normally acts as very strong resistance in every market. And since you're short the market, the last thing you need is a sharp reversal higher off the EMA line, so why risk it?

Be aware that some stocks have greater (lesser) volatility and price swings than others, so what is an extreme 12/50 EMA spread in GDX may not be as extreme as it is in a stock like AUY or SWC. Work with a handful of stocks or futures contacts at first, getting to know what's extreme and what's normal in terms of the 12/50 EMA spread. EmaRat will be there for you, willing to help you as you attempt to do what so few traders can do successfully — timing consistently profitable countertrend trades in stocks and commodities that have simply moved too far, too fast.

Here's the MetaStock indicator code for EmaRat. Feel free to adjust it to your own trading style, as needed:

Mov(C,12,E)/Mov(C,50,E)

The detrend oscillator uses a 10-period simple moving average length to determine the cyclical component of a typical 20-day price cycle, as measured from swing low to swing low.

Donald W. Pendergast, Jr.

Donald W. Pendergast is a financial markets consultant who offers specialized services to stock brokers and high net worth individuals who seek a better bottom line for their portfolios.

Title:	Writer, market consultant
Company:	Linear Trading Systems LLC
	Jacksonville, FL 32217
Phone # for sales:	904-239-9564
E-mail address:	lineartradingsys@gmail.com
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