Moving Averages

HOW TO TRADE
the
Highest Probability
Opportunities:
MOVING AVERAGES
EWI eCourse Book
How to Trade the Highest Probability Opportunities:

Moving Averages
By Jeffrey Kennedy, Elliott Wave International
Chapter 1 – Defining the Moving Average and Its Components

A rundown of different types of moving averages and how to use a dual moving average crossover
system
Chapter 2 – The Most Popular Moving Averages

The specific moving average systems that stock and commodities investors use
Chapter 3 – Moving Averages and the Wave Principle

How moving averages can help you see wave patterns more easily
Chapter 4 - How To Trade Using Moving Average Compression

How to recognize and use one of the most dynamic analytical trading opportunities
Chapter 5 - Determining the Trend with Stoplight Trend Analysis

How to identify whether a trend is up, down or non-existent with Jeffrey Kennedy’s Stoplight trend
analysis system
Chapter 6 - Questions and Answers

Jeffrey Kennedy answers questions asked by How to Trade the Highest Probability Opportunities:
Moving Averages webinar participants.
Introduction
My name is Jeffrey Kennedy, and I’m the editor of Futures Junctures, Elliott Wave International’s premier com-
modities forecasting service. In this course, I will teach you how to use moving averages to trade the highest
probability opportunities. By the time you have finished the course, you will know (1) what a moving average
is and which ones are the most popular; (2) how to use moving averages to identify Elliott waves; (3) what
my favorite moving average trade set-up is; and (4) how to use Stoplight trend analysis, an easy-to-understand
technique for deciphering market trends.
Editor’s note: This webinar was originally presented live on August 13, 2008.
How to Trade the Highest Probability Opportunities: Moving Averages

© 2009 Elliott Wave International — www.elliottwave.com 1
Chapter 1 — Defining the Moving Average and its Components
Chapter 1
Defining the Moving Average and Its Components
A moving average is simply the average value of data over a specified time period, and it’s used to figure out
whether the price of a stock or a commodity is trending up or down. Although simple to construct, moving
averages are dynamic tools, because you can choose which data points and time periods to use to build them.
For instance, you can choose to use the open, high, low, close or midpoint of a trading range and then study
that moving average over a time period, ranging from tick data to monthly price data or longer.
The most common types of moving averages are simple, exponential, weighted, smooth, centered, adaptive,
and triangular. Of these, the three most often used by traders and analysts are the simple moving average, expo-
nential moving average and weighted moving average, so I will refer to them often throughout this course.
Figure 1-1
Figure 1-1 plots three moving averages
on a daily chart for Corn. The red line
represents a 10-period weighted mov-
ing average, the green line represents a
10-period exponential moving average,
and the blue line is a 10-period simple
moving average. Without going into
a long discussion of the math behind
these moving averages, I want to point
out that the exponential moving average
and weighted moving average put more
value on the front end, which means
that while a 10-period simple moving
average assigns the same weight to
each period, exponential and weighted
moving averages put more weight on
the most recent data.
As you can see in Figure 1-1, the varia-
tion is noticeable but not enough to
make a big difference in their representation. I have worked with all types of moving averages over the years,
and I rely mostly on the simple moving average, because simple things usually work best. In this course, I will
focus most on the 10-period simple moving average.

The Dual Moving Average Crossover System

When designing a trading system using moving averages, most people will begin with a dual moving average
crossover approach, as shown in Figure 1-2. The 5-period simple moving average is shown as a thin blue line.
The 10-period simple moving average is the thick black line.
In analysis and technical studies, you’ll often see a chart marked like this, and you will also see some exciting
price moves as a result. Look at how the two lines cross over one another at the top of the chart, indicated by
the red arrows to the downside. These red arrows indicate that the 5-period simple moving average crossed
below the 10-period simple moving average.
Figure 1-2
At first, you might think, “Wow, that
looks like a great trade.” Since the
trendline break gave a signal, you figure
you would have been short and made
lots of money. However, what you need
to realize is that a moving average is
actually a trend-following indicator: it
always lags the market. This means that
whenever the market is trending, such as
during the periods marked with a blue
line, moving averages work nicely to
give you worthwhile signals.
Figure 1-3
But they can also give you false signals,
particularly when you enter a sideways
market or a market where there’s no
trend, circled in Figure 1-3. From all
my years of testing moving averages, I
have learned the hard way that there is
no one magic moving average setting.
There is no period that works across all
markets and time frames.

Figure 1-4
So, if you’re interested in optimizing
a market according to a moving aver-
age or a moving average crossover
approach, I recommend the following
actions:
1. First, identify the specific
market and time frame you
want to study, such as Corn
on the daily level.
2. Second, make sure the period
you are initially testing con-
tains both a trending phase
and a non-trending phase.
This step will ensure that your
results do not include a trend
bias.
3. Then perform a simple optimization to identify which moving average parameters are best to use.
4. Once you complete those steps, you will then want to examine a totally different period of time, some-
thing that may have occurred months or even years ago. This step is extremely important because it is
similar to what some refer to as a Double-Blind study. In the “biz,” it is referred to as Out-of-Sample
Data testing, the result of which will determine if you have identified a viable mechanical trading
system.

Moving Average Price Channel System

Figure 1-5
One way to overcome whipsaws or
false signals with a dual moving aver-
age crossover system is by employing
a moving average price channel. The
moving average, the higher black line
in Figure 1-5, is a 20-period simple
moving average of the high. The lower
black line is the 20-period simple mov-
ing average of the low. The moving
average price channel is the area in be-
tween. The blue line is a 5-period simple
moving average of the close.
In Figure 1-5, the buy and sell signals
are marked with arrows. A buy occurs
when the 5-period simple moving aver-
age of the close, or the blue line, crosses
above the upper boundary line of our
price channel. A sell is when the blue
line crosses below the lower line, or
the 20-period simple moving average
of the low.
Using a price channel cuts down on the number of whipsaws because it creates a more significant hurdle for
prices to overcome before a signal is generated. In the same figure, notice that since the move up began in late
March 2008, there were buy signals to the upside, as well as a nice move to the downside, which signaled the
short seen here in Corn.
When designing a mechanical trading system using moving averages, dual moving averages or moving aver-
age channels, it is important to remember that what may work in Corn may not work as well in the Canadian
Dollar and vice versa. Again, there’s no magic setting.

Combining the Crossover and Price Channel Techniques

Figure 1-6
Another way to work with moving aver-
ages is to combine the crossover tech-
nique with the price channel technique.
The price channel system is shown on a
chart of E-mini S&P 500 in Figure 1-6.
The green arrows identify when the blue
line crosses the 20-period moving aver-
age of the higher line, which is a 20-pe-
riod simple moving average of the high.
The red arrows indicate a close below.
The circled diamonds indicate when
the 5-period moving average crossed
below the 10-period. (In an attempt to
make this price chart easier to interpret,
I have not shown the 10-period simple
moving average.)
Essentially, this method combines the
best of two moving average systems into
one. Its purpose is to give you a slow entry using the moving average price channel system, which eliminates
false trading signals, but a quick exit to protect profits by using a dual moving average crossover system.
Figure 1-7
To further explain this methodology,
look at the Net Logic stock chart in Fig-
ure 1-7. See the circled green arrow and
the circled red diamond, which indicate
a slow entry but a quick exit. If I had
to pick between a dual moving average
crossover system versus a price channel
system, I would favor the price channel
system, because it more easily identifies
areas of support where you can expect
trend reversals.

Figure 1-8
In Figure 1-8, notice how the market
– and especially the moving average –
dipped into the price channel and then
turned back up, which is marked with
the first small vertical line. This is an
excellent indication of a countertrend
move within a larger upturning market.
Then the same thing happened again,
marked by the second small vertical
line.
Figure 1-9
Figure 1-9 is an updated price chart of
the same stock. In the downside within
the stock’s sell-off, prices pushed into
the price channel and then turned back
down, and you can see the successful
break of the price channel on the far
right of the chart. From there, let’s as-
sume the price channel continues higher.
From a trading perspective, I would
consider this situation to be a buying
opportunity for a move above the ex-
treme, especially if prices pulled back
into the channel and then began to turn
back up, because this is the signature
of a countertrend move within a larger
uptrending market.

Figure 1-10
This chart of Corning in Figure 1-10
shows how each time the market moves
into the price channel (marked by the
short vertical lines), it signals a buy-
ing opportunity. When Corning’s price
breaks through the price channel (in-
dicated by the short diagonal line), the
trend has turned to the downside. So,
we have a clear uptrend followed by a
clear downtrend. This moving average
price channel identifies countertrend
moves with an uptrending market.
Notice how the blue line keeps revisit-
ing the 20-period moving averages of
the high or 20-period moving average
of the close.
It’s very similar to Elliott wave analysis, where impulse waves consist of five moves and a three-wave correc-
tion. Buying opportunities are in wave 2 and wave 4, and there’s a selling opportunity at the top of wave 5,
which you can see from the wave pattern drawn below the stock chart.

Chapter 2 — The Most Popular Moving Averages
Chapter 2
The Most Popular Moving Averages
In this section, I will explain the moving averages that are most popular on the Street, both for the stock ex-
changes and the commodities markets. Among technicians who work mainly with stocks, the most popular
moving average is a 50-period simple moving average of the close and a 200-period simple moving average
of the close. In fact, these settings are so popular that you may have even heard them referred to by technical
analysts on CNBC.
Figure 2-1
Figure 2-1 shows an example of when
the 200-period moving average provid-
ed resistance in an April-to-May move
up in the Dow Jones Industrial Average
(circled on the heavy black line). As you
can see, the 50-period moving average
provided support (circled on the blue
line).
Figure 2-2
Notice in Figure 2-2 how the 50-period
moving average provided resistance in a
daily time frame, as marked by the short,
red vertical lines. But you can also see
how the Dow penetrated the 50-period
simple moving average line decisively
and pushed up higher. That’s a good
example of why you should remember
that although moving averages can be
a wonderful tool, these little blue and
black lines can also become ropes that
tangle you mentally and emotionally if
they’re misused.

Figure 2-3
For other markets, such as commodities
and currencies, it’s the 10-period and
40-period simple moving averages that
are popular. In Figure 2-3 of Sugar, you
can see how the 10-period moving aver-
age crossed below the 40-period moving
average line and then came back to mod-
erately test it before reversing sharply to
the downside (marked by the red line).
Some commodity traders highly value
the 10-period simple moving average
of the close and the 40-period simple
moving average of the close.
Figure 2-4
Now, let’s look at another popular set-
ting with regard to a weekly time frame
that I like: It’s a 13-week setting. One
way to think of a moving average is that
it’s an automated trend line. This Sugar
chart features a 13-week simple moving
average of the close on a weekly time
frame, in Figure 2-4. The 13-period
simple moving average of the close
works equally well in commodities,
currencies and stocks. In this chart,
prices crossed the line (marked by the
short, red vertical line), and that cross
led to a substantial rally. This chart also
shows a whipsaw in the market, which
is circled. Later, I’ll explain a tool that
might help you overcome whipsaws like
these where the market gyrates up and
down almost in place.

Figure 2-5
Another popular moving average setting
that many people work with is the 13-
and the 26-period moving averages in
tandem. Figure 2-5 shows a crossover
system, using a 13-week and a 26-week
simple moving average of the close
on a 2004 stock chart of Johnson and
Johnson. Obviously, the number 26 is
two times 13. During this four-year pe-
riod, the range in this stock was a little
over $20.00, which is not much price
appreciation. This dual moving average
system worked well in a relatively bad
market by identifying a number of buy-
side and sellside trading opportunities.

Chapter 3 — Moving Averages and the Wave Principle
Chapter 3
Moving Averages and the Wave Principle
In this section, I will show you something you may not have known about moving averages. You can use them
to identify Elliott waves. In fact, if you’re new to the Wave Principle, I recommend using a moving average to
get you started, and the reason why is that a moving average overlaid on a price chart will help train your eye
to see developing Elliott wave patterns.
Figure 3-1
For an example of a schematic Elliott
wave, look at Figure 3-1. If you’ve read
The Elliott Wave Principle by Robert
Prechter and A.J. Frost, you know that
wave patterns are illustrated as line
diagrams.
Figure 3-2
When you look at a real price chart rath-
er than a schematic, the basic chart is
typically an open-high-low-close price
chart. Each price bar represents a single
period and is illustrated by a vertical line
with a small mark to the left and a small
mark to the right as seen in Figure 3-2.
The little lower line on the left-hand
side of the vertical bar is the open; the
little upper line on the right-hand side of
the vertical line is the close; the top of
the line is the day’s high or that trading
period’s extreme; and the bottom of the
line is that trading period’s low.
Here’s the thing: Whenever you’re
making the transition from looking at a
textbook diagram to actually counting
Elliott waves on a real price chart, it can be confusing to the eye. If you use a moving average, it will help you
to see the wave pattern more easily.

Figure 3-3
Let me prove my case more thoroughly
with this chart of Corn. In Figure 3-3,
the blue line is an 8-period simple
moving average of the close, which
clearly shows that a five-wave decline
has unfolded from the upper left-hand
side of this price chart. With the aid
of a moving average, the subdivisions
within this selloff are more easily dis-
cernible than with the untrained naked
eye. Also, notice that the slope of the
move up in wave 4 is shallow. This
detail is important because one of the
key characteristics of countertrend price
action is that it moves slowly, thus its
slope will be inherently more shallow
than what one can expect to encounter
when a motive wave is in force.
Figure 3-4
This price chart of Sugar in Figure 3-4
exhibits more Elliott wave patterns,
which can, again, be seen more clearly
by viewing this open-high-low-close
price chart along with a moving aver-
age. This moving average is still an
8-period simple moving average of
the close, though you could also use a
5-period or even an exponential moving
average.
Again, there’s no magic number when it
comes to moving averages. What mat-
ters is that you find something you’re
comfortable with and that you apply
it consistently. If there’s any magic to
moving averages that I can share with
you, that’s it. Find what you like, find
what works for you and apply it consistently.
Back to the chart: Notice the three-wave move on the left-hand side of the chart, marked by the labels A, B,
and C. Wave A is a move to the downside, followed by a three-wave move up in wave B. Next is a dip, an
advance, another move to the downside and a sideways move (wave iv), followed by a press down to complete
wave C. Next you can see an advance, another dip down in the moving average and another rally. In fact, you
can see waves 1, 2, 3, 4 and 5. The moving average actually helps train your eye to identify the wave patterns
that are unfolding.

Figure 3-5
In the previous figure, I identified wave 3
within a developing five-wave move.
Now, by applying the moving average
on a smaller time frame of 60 minutes,
you can clearly see the wave 3 subdivi-
sions in Figure 3-5.
Figure 3-6
If we look at these same price charts
on even a smaller time frame, the same
clear Elliott waves are present and ap-
parent. In Figure 3-6, look at wave 3,
followed by waves a and b and the mov-
ing average. It comes down, bounces,
comes down again, bounces again and
comes down one more time, which cre-
ates waves a, b, and 1, 2, 3, 4 and 5 of
wave c.

Fibonacci Values and Moving Averages

Remember that, according to R. N. Elliott’s book, Nature’s Law, the Fibonacci sequence is the mathematical
basis of the Wave Principle. The most common Fibonacci multiples for wave three are 1.618, 2.618 and 4.236,
this last multiple being a formidable objective for third-wave rallies. Next in the Fibonacci sequence is 6.854.
I look for these common multiples when I’m determining how far wave 3 will move in relation to wave 1.
The most common Fibonacci retracement for fourth waves is .382. Other frequently occurring retracements
are .50 and .618. To determine fifth-wave objectives, remember that waves 5 and 1 are usually equal. A fifth
wave can also equal a 1.618 multiple of wave 1 or a .618 multiple of waves 1 through 3.
But how does this Fibonacci analysis work with moving averages? Here’s where I would like to introduce my
Fibonacci extension tool, which involves using the extremes of moving average values instead of actual price
highs and lows.
Figure 3-7
Let me show you exactly how to do that
on this 240-minute chart of Corn (Fig-
ure 3-7). To make projections using the
moving average, use the extremes in the
moving average (circled), which mark
waves 1 and 2. I previously mentioned
that 4.236 is a formidable Fibonacci
objective for third waves. The pencil
points at the 4.236 line, and you can see
that the moving average pushed moder-
ately below this level before reversing
in wave 4.

Figure 3-8
Now the most common Fibonacci re-
tracement for fourth waves is a .382
multiple of wave three. However, shal-
lower and deeper fourth wave correc-
tions occur. And one instance where
shallow corrections are quite common
is when the larger trend in a market is
deeply ingrained. When this is indeed
the case, as it is in Corn, a shallow Fi-
bonacci retracement can be expected,
specifically, .236. As you can see in
Figure 3-8, wave 4 traveled to just be-
low the .236 retracement of wave 3 of
its moving average length.
Figure 3-9
In Figure 3-9, I’m projecting the fifth
wave, using the distance traveled in
wave 1, which is a common fifth-wave
objective. Take the distance the mov-
ing average traveled in wave one and
project that distance downward from
the extreme of the moving average that
occurred in wave four. In this instance,
the moving average nearly reached the
2.618 multiple of the moving average
length that transpired in wave one.
Combining this Fibonacci moving
average approach with the traditional
use of Fibonacci within the context of
the Wave Principle makes it easier to
identify multiple layers of Fibonacci
support and resistance.

Figure 3-10
As an overview of how to use moving
averages with Fibonacci values, I pro-
vide Figure 3-10. To project Fibonacci
multiples for wave 3, I measure the
distance traveled in wave 1 and extend
that distance from the extreme of wave
2. The multiples I use for wave 3 are
1.618, 2.618 and 4.236. Occasionally, I
see 2.0, which I’ve put off to the side.
Also, the guideline of wave equality
states that wave 5 typically equals the
distance traveled in wave 1. The next
relationship to look at is 1.618, but,
depending on the markets and its sub-
structure, you may see wave 5 equal a
2.618 multiple of wave 1.
There are times when I use waves 1 through 3 to identify fifth waves, especially when the fifth wave extends,
as is often the case in commodities. Here are the three relationships to look for:
1. Sometimes wave 5 equals a .618 multiple times the distance traveled in wave 1 through wave 3.
2. Sometimes wave 5 equals waves 1 through 3.
3. Sometimes wave 5 equals a 1.618 multiple times the distance traveled in waves 1 through 3.
Figure 3-11
A common problem traders make is to
enter a trade too early. This Elliott wave-
based moving average approach is one
way traders can overcome this problem.
While some traders may begin initiating
short positions on a break of the extreme
of wave 1, identified by the red line in
Figure 3-11, it sometimes is beneficial
to wait for the moving average to also
penetrate the same price level. As you
know, moving averages are lagging in-
dicators, which is why signals derived
from them lag behind current price ac-
tion. Even so, this tendency of moving
averages to act as a time stop can slow
down your trading and prevent you from
entering a trade too early.

Chapter 4 — How To Trade Using Moving Average Compression
Chapter 4
How To Trade Using Moving Average Compressions
Figure 4-1
The moving average compression is my
favorite moving average trade set-up
and is inspired by the work of Daryl
Guppy. Look at the Soybeans price chart
in Figure 4-1, which contains six mov-
ing averages — 5, 10, 15, 20, 30 and
40 — that represent a different period
of time from the short term to the long
term. Moving average compression is
the point (circled on this chart) where all
those moving averages become one, or,
as I often say, when they “get married.”
Compression is significant because it
happens only when different classes of
investors with different objectives and
time frames think the same thing at the
same time. This condition in the market
cannot be maintained for long.
To explain, let’s say that the 40-period moving average in this example represents a trader with a two-month
time frame while the 5-period moving average represents a trader with a two-hour time frame, and so on. It
is uncharacteristic for traders who have different investment time frames to agree on anything. So when they
do — which will be represented by multiple moving averages becoming tightly bound — remarkable price
moves can result. It’s like shaking a can of Coca-Cola and taking the top off — it explodes. That’s how dynamic
moving average compression is.
In the case of this Soybeans chart, this moving average compression took the shape of a contracting triangle
in terms of Elliott wave analysis, and Soybeans pushed up to $16 a bushel.

Figure 4-2
Now, look at the Coffee chart in Fig-
ure 4-2, which is a great example of
moving average compression. In June
2008, all of the lines were bound tightly
together, which led to a dynamic move
to the upside. The same moving aver-
age compression also happened earlier
that year.
Figure 4-3
Figure 4-3 provides another beautiful
example of a moving average compres-
sion. Corn prices went from $6.50 to
nearly $8 a bushel as a result. Again,
notice how tightly the lines are bunched
together prior to the explosive price
move up. This chart shows the transi-
tion from a point of moving average
compression to market expansion.

Figure 4-4A and Figure 4-4B

Johnson and Johnson is the subject
of the monthly price charts shown in
Figures 4-4A and B. Notice where the
compression is – at the point where all
of the moving averages began to come
together in the top chart. As a result of
this compression, prices moved dynami-
cally as shown in the bottom chart.

Figure 4-5
Figure 4-5 is also a monthly price chart,
but of the Canadian Dollar. Notice the
moving average compression starting
in 1996. This happened in this market
only once from 1988 through 2006. If
you can possibly be patient enough to
wait for this kind of move, do so, and
you’ll be right more often than not.
Overtrading is another problem many
traders face; and because moving aver-
age compression is infrequent, it can
slow down your trading.
Figure 4-6
Notice on the far right of this weekly
chart of the British Pound (Figure 4-6)
that the 40-period moving average
didn’t quite get down to where the rest
of the moving averages were “getting
married.” But we did have everything
from the 30-period on down, which
means it still counts as a version of
moving average compression. Look at
the result of the move – a sharp drop
– which is why this market condition
is my favorite moving average trade
set-up. All I have to do is wait for all of
these moving averages to come together
and form one line. Then I know an op-
portunity is coming.

Figure 4-7
Figure 4-7 is a five-minute price chart,
primary session, of the S&P e-mini.
On this particular Tuesday, all moving
averages came together nicely, which
signaled that the market was about to
make a nice move. As you can see, there
was a subsequent sell-off.
Figure 4-8
You can even utilize this technique on
a minute intra-day level. Figure 4-8 is
a one-minute price chart of the S&P e-
mini. Notice that a sizable price move
erupted at 1:20 p.m. as a result of the
moving average compression that pre-
ceded it. Bottom line — when moving
average compression takes place, watch
out for what’s about to happen. It’s dy-
namic. All you have to do is be patient,
wait for it to form. And when it does
form, be ready to act.

How to Determine Entry and Exit Points for Moving Average Compressions
Figure 4-9
To determine the entry point for a mov-
ing average compression trade setup,
you will need to look for one of two
things – either the point where the range
of a price bar encompasses all the mov-
ing averages or the point where all the
moving average lines form a single line.
Notice in Figure 4-9 the red mark that
identifies a single price bar whose range
encompasses all the moving averages.
Figure 4-10
Once you identify the price bar that
includes all your moving averages,
make note of that bar’s high and low
(Figure 4-10). These levels are impor-
tant because they define your breakout
levels.

Figure 4-11
When prices close above or below the
identified levels, that indicates the direc-
tion of the breakout. Notice in Figure
4-11 that the initial close below the red
line was an early warning indication of
the direction of the break out. From a
trading perspective, a trader can take a
short position at this time with an initial
protective stop at the high of the bar that
breaks out or the high of the bar that
encompasses all the moving averages.
Figure 4-12
In this instance, a simple exit strategy
would be to exit the position on a close
above one of the faster moving aver-
ages. In the Canadian Dollar, Figure
4-12, a close didn’t occur above the
10-period simple moving average until
February 1999, well after a month-long
collapse in this currency.
Summary
To use moving average compression as a trade setup, wait to identify a bar that encloses all 6 or 10 or 15
moving averages, whatever the number you are using may be. Play the break-out against the high or the
low of the bar that encompasses all the moving averages. Then, use one of the faster moving averages as a
trailing stop.

Chapter 5 — Determining the Trend with Stoplight Trend Analysis
Chapter 5
Determining the Trend with Stoplight Trend Analysis
Moving averages work well in a trending market, but not in a non-trending market. To identify when there’s
no trend in the market, I created what I call Stoplight trend analysis, which is a color-coding system that iden-
tifies which trend is which. I color the price bars green when the trend is up, red when the trend is down, and
yellow when there is no trend.
Figure 5-1
Stoplight trend analysis incorporates three
moving averages. Earlier, I explained how
to use a dual moving average crossover
system. Figure 5-1, though, shows three
moving averages. The settings for these
three moving averages are 5, 15 and 30.
I use these settings because they simply
represent weeks. The five-period mov-
ing average equals one week of trading,
the 15-period moving average represents
three weeks worth of trading, and the
30-period moving average equals six
weeks of trading.
Figure 5-2
So, what does Stoplight actually do? The
Stoplight technique determines whether
the market is trending up, down or not at
all, which is important because you don’t
want to trade in a non-trending market. In
Figure 5-2, I color-coded the bars: green
bars (trend is up), yellow (no trend), and
red (trend is down). The Stoplight tech-
nique indicates when the market is green
and good to go; when the market is not
trending and to stay put; or when to raise
protective stops or lock in profits.
Stoplight trend analysis indicates when to
play the buy-side in a bull market when
the bars are green, or when to play the
downside in a bear market when the bars
are red. When the bars are yellow, that’s a
warning light that says “do nothing.”

Figure 5-3
Specifically, bars turn green when the
5-period moving average (the green
line) is above the 15-period moving av-
erage (the yellow line) and the 30-period
(the red line), as seen in Figure 5-3. If all
three degrees of trend – the 5-, 15- and
30-period – are positive, the trend is up,
and I can play the buy-side.
Red bars are the opposite. If the green
line is below the yellow line and the red
line, the trend is to the downside. Then
I can sell all day long.
When the market is yellow, either
the 5-period is less than the 15-pe-
riod but greater than the 30-period,
or the 5-period is greater than the
15-period but less than the 30-period.
I do nothing.
This is a really simple technique that uses three moving averages of different scale, period and duration to
help answer one of the most important questions any market analyst must ask himself or herself. What is the
trend? Is the trend up? Is the trend down? Or is there no trend at all? Because you don’t want to trade in a
non-trending market.
Figure 5-4
Now, let’s see what an excellent job this
Stoplight system does to distinguish
between trending and non-trending
phases of a market. Figure 5-4 shows
the Stoplight system on a monthly price
chart of the Dow Jones.

Figure 5-5
Going back in time to 1984, the Dow
was in a neutral condition, followed by
green bars, which is marked with a short
red line in Figure 5-5. Then the bars
turned gold, which indicated a consoli-
dation; often, these gold bars represent
corrective or countertrend pullbacks
within the larger trend.
Figure 5-6
Then, from 1985 to 1987, prices moved
up (Figure 5-6). Red bars were next,
followed by another neutral market
condition.

Figure 5-7
Then, going forward in time (Figure
5-7), prices moved up in the DJIA,
all the way into the 2000 high. Even
then, the market gave us some clues:
The green bars followed by the gold
bars indicated that there was no trend
in the market. Then we have a couple
of green bars. None of the highs of the
monthly green bars were taken out, and
we go back to gold. Then there is the
first red bar in the market, which led to
significant selling more than once. This
shows you that sometimes making no
trade can be the most profitable trade
you can make.
Figure 5-8
Also, in Figure 5-8, you can see the
small moving average compression that
exists in the market (circled).

Figure 5-9
Now, let’s shift to a five-minute time
frame of the S&P e-mini in Figure 5-9.
Again, three moving averages – 5, 15
and 30 – are shown. Furthermore, notice
the moving average compression that
occurs on this price chart, where all of
the lines come together (circled).
Figure 5-10
If you look closely at the bottom of this
price chart, as shown in Figure 5-10, you
can see red bars followed by gold and
then green. Again, this is your yellow
light – you’re in the period of time when
the market is saying, “Whoa, hold on.
Don’t do anything. Something’s going
on here.” Overall, you can see the transi-
tion from a bearish, red-bar downtrend
to where the market begins turning to
the upside.

Figure 5-11
In Figure 5-11, the market’s neutral con-
dition is apparent by the gold-colored
price bars. And again, this is important
information for traders who were long
prior to this development, because it is
a warning sign that a change in trend
could be occurring or that the market is
taking a rest. This kind of knowledge
helps you to be proactive with your
positions. Once the price bars in this
example turn, you then know that the
prior trend is exhausted and that the
immediate trend is now down.
Editor’s Note: If you don’t have color-coding capability on your trading program, please contact your trading
program’s customer service department for instructions on how to set it up.
Dual Time Frame Applications and Stoplight Trend Analysis

Figure 5-12
You can also use Stoplight trend analysis
on two different time frames, as shown
in Figure 5-12, a weekly and daily price
chart of the Australian dollar. Notice
the gold bars on the left-hand chart
that formed in early 2008. The color of
these price bars indicate that there is no
discernible trend in this market at this
time and that you should do nothing.
Once the price bars turn green, the trend
is confirmed as up.

Figure 5-13
Next, I’m going to dial down to the daily
level, which is the chart on your right in
Figure 5-13. Ideally, I’m looking for a
green bar on both the daily and weekly
time frames. In other words, I want
price evidence of an upward trend on
both time frames, because if both the
weekly trend and daily trend are up,
the market is giving you two thumbs
up to go long.
Figure 5-14
If you’re an intra-day trader, you may
you want to try this method on a 5- and
2-minute time frame. In this example in
Figure 5-14, it’s the S&P e-mini. Notice
the moving average compression in the
chart on the right as well (circled).
The dual green light situation is created
when both 2- and 5-minute price bars
are green. The ideal trade setup occurs
when the 5-minute trend is green, and
you see a transition in the bar colors
on the 2-minute price chart going from
green to yellow and then back to green.
This formation identifies countertrend
moves within larger trending markets.
If you’re more of a long-term investor
than a short-term trader or speculator,
look at daily and weekly, or weekly
and monthly charts. As you saw in the
monthly DJIA chart, the Stoplight tech-
nique told you what the primary trend
was for a long time.

Last Thoughts on Moving Averages

Moving averages have been around since before the stock market began, but I hope I’ve shown you some new
ways to look at them and to apply them. And while it’s exciting to learn about moving average compression
by itself, I think that being able to use the Stoplight methodology to identify trending or non-trending markets
is, in some ways, brilliant.
Also, if you’re new to the Wave Principle, be sure to use a simple moving average to help you see wave pat-
terns on price charts. Then, go beyond that by applying measurements based on moving averages and using
Fibonacci values to identify high-probability objectives, such as retracements and extensions.

Chapter 6 — Questions and Answers
Chapter 6
Questions and Answers
Q. Is back-testing the only way to optimize the moving averages for a given market?
Kennedy: Yes. Begin by visually inspecting the market or time frame. For example, if you
work with the Canadian dollar on a daily basis, use either the dual moving average crossover
approach or the price channel approach (which is the one I prefer). For example, if you examine
the Canadian dollar 10 to 15 years back in five-year increments, you should be able to find a
mean that works. Back-testing is strenuous and laborious. It’s easier if you have a good program
to help you, such as Genesis Navigator or Trade Station.
Q. Do most trading programs have the formulas for simple moving averages to chart the
highs and lows?
Kennedy: Most charting platforms, such as Ninja Trader, Super Charts, Meta Stock, etc., have
moving average capability. To create a moving average channel, change the setting in your
program from the moving average of a close to the moving average of a high.
Q. Can I open trades in one time frame and determine the trend in another?
Kennedy: Yes, you can.
Q. In a downtrend, should I wait for yellow bars on the 5-minute chart before going short?
Kennedy: Green bars mean that the trend is up, yellow bars mean that the trend is neutral, and
red bars mean that the trend is down. The idea behind the methodology is to always trade in
the direction of the trend and to use countertrend moves as buying or selling opportunities. For
example, if the 15-minute and 5-minute both show red bars, it means that both the long-term
and short-term trends are down. Then, what I like to see is the 5-minute bar color go from red
to yellow to green. When the bar color turns back to red, which is in agreement with the longer-
term time frame, I believe the market is offering a shorting opportunity.
Q. What do I select for a longer time frame, and how do I resolve conflicting trends?
Kennedy: I like to use 1-to-3 or 1-to-4 ratios when using a dual time-frame approach. So if you
trade off the five-minute, use the 15- or 20-minute price charts to determine the trend. Regarding
conflicting trends, if the longer time frame is down, I avoid buy signals (basis: the five-minute
chart) against the trend and use those signals as exit points.
Q. On the daily chart, do I use the shorter time frames for buy signals?
Kennedy: If the trend is up (basis: the daily price chart), then you’ll look for buy signals based
on the shorter time frames, such as 60 minute or 120 minute.
Q. Can line charts serve as well as moving averages for labeling Elliott waves?
Kennedy: Line charts are fine. The reason I use moving averages is to reduce noise from up
and down movements in prices.
Q. How do I set the moving averages?
Kennedy: All of the moving averages I used were set for the close. The bars are colored based
on the averages, not price. So use this formula: 5 sma < or > 15 or 30, etc.

EWI eBook
How to Trade the Highest Probability Opportunities:

Moving Averages
By Jeffrey Kennedy, Chief Commodities Analyst, Elliott Wave International
© 2009 Elliott Wave International
Published by New Classics Library
For information, address the publishers:
New Classics Library

Post Office Box 1618
Gainesville, Georgia 30503 US
www.elliottwave.com
ISBN: 978-0-932750-85-3

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HOW TO TRADE

How to Trade the Highest Probability Opportunities:

By Jeffrey Kennedy, Elliott Wave International

Chapter 1 – Defining the Moving Average and Its Components

Chapter 2 – The Most Popular Moving Averages

Chapter 3 – Moving Averages and the Wave Principle

Chapter 4 - How To Trade Using Moving Average Compression

Chapter 5 - Determining the Trend with Stoplight Trend Analysis

Chapter 6 - Questions and Answers

How to Trade the Highest Probability Opportunities: Moving Averages

How to Trade the Highest Probability Opportunities: Moving Averages

The Dual Moving Average Crossover System

How to Trade the Highest Probability Opportunities: Moving Averages

How to Trade the Highest Probability Opportunities: Moving Averages

Moving Average Price Channel System

How to Trade the Highest Probability Opportunities: Moving Averages

Combining the Crossover and Price Channel Techniques

How to Trade the Highest Probability Opportunities: Moving Averages

How to Trade the Highest Probability Opportunities: Moving Averages

How to Trade the Highest Probability Opportunities: Moving Averages

How to Trade the Highest Probability Opportunities: Moving Averages

How to Trade the Highest Probability Opportunities: Moving Averages

How to Trade the Highest Probability Opportunities: Moving Averages

How to Trade the Highest Probability Opportunities: Moving Averages

How to Trade the Highest Probability Opportunities: Moving Averages

How to Trade the Highest Probability Opportunities: Moving Averages

Fibonacci Values and Moving Averages

How to Trade the Highest Probability Opportunities: Moving Averages

How to Trade the Highest Probability Opportunities: Moving Averages

How to Trade the Highest Probability Opportunities: Moving Averages

How to Trade the Highest Probability Opportunities: Moving Averages

How to Trade the Highest Probability Opportunities: Moving Averages

Figure 4-4A and Figure 4-4B

How to Trade the Highest Probability Opportunities: Moving Averages

How to Trade the Highest Probability Opportunities: Moving Averages

How to Trade the Highest Probability Opportunities: Moving Averages

How to Trade the Highest Probability Opportunities: Moving Averages

How to Trade the Highest Probability Opportunities: Moving Averages

How to Trade the Highest Probability Opportunities: Moving Averages

How to Trade the Highest Probability Opportunities: Moving Averages

How to Trade the Highest Probability Opportunities: Moving Averages

How to Trade the Highest Probability Opportunities: Moving Averages

How to Trade the Highest Probability Opportunities: Moving Averages

Dual Time Frame Applications and Stoplight Trend Analysis

How to Trade the Highest Probability Opportunities: Moving Averages

How to Trade the Highest Probability Opportunities: Moving Averages

Last Thoughts on Moving Averages

How to Trade the Highest Probability Opportunities: Moving Averages

How to Trade the Highest Probability Opportunities: Moving Averages

How to Trade the Highest Probability Opportunities:

By Jeffrey Kennedy, Chief Commodities Analyst, Elliott Wave International

© 2009 Elliott Wave International

Published by New Classics Library

For information, address the publishers:

New Classics Library

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