Trend Following With a Moving Average and the Williams Percent Range (WPR) Oscillator

April 12, 2013 03:00 AM

The concept behind trend following is that financial markets tend to exhibit trends that can be exploited for profit. Due to global imbalances, supply/ demand constraints and long tail events, such trends often tend to last longer than one would normally expect, allowing significant opportunities for trend followers. The successful trend follower is therefore able to make money, not by studying the fundamentals, but by spotting trends using technical indicators or price action and then jumping on the trend and riding the wave to its conclusion.

Generally, trend followers will miss the bottom or top of a market but they will often catch a big chunk of the middle.

Moving averages

Moving averages have several applications however, in finance they are used to show the average value of a security’s price over a set period of time. They are easy to calculate as you just add up the different closing prices of a security over a certain number of periods then divide by the number of periods. Of course, nearly all charting applications are able to do this for you now and they usually offer different types of moving averages too, such as exponential averages and weighted averages.

Moving averages, though, are an extremely popular tool among trend followers and traders since they act to solve a number of problems that are inherent with trying to predict financial markets.

First, moving averages are able to show the direction of a market much more objectively than the drawing of trend lines or other measures. Since they use the real price sequence of the market they offer a true picture of the real direction of the market.

Second, moving averages are useful since they filter out noise and smooth financial data. This means traders can base their trading decisions on the real trend of the market and not be thrown off course every time the market spikes up or down against the trend.

Now we know the advantages of using moving averages we can see how they are used by traders to find trends. In fact, traders often use them in different ways.

Moving average crossovers

The most common method used by trend followers to spot a trend is by watching out for the crossover of two different timed moving averages and this method can easily be seen on any price chart.

When a faster moving average (such as a 20 day MA), crosses over a slower moving average (such as a 50 day MA) it signals that the market is trending higher, since the most recent price data shows the market moving higher, more quickly than the older price data. This is clearly shown in the daily chart below.

As you can see, the 20 day MA crossed over the 50 day MA on 13 December signaling a new uptrend was in place. The trend follower would have bought the market on this signal and will stay long until the faster moving average crosses back under the slower moving average.

When the faster moving average crosses under the slower moving average, it is a signal that a down trend has started. In this case a trend follower will either close his long position or enter a new short position on the crossover.

One of the most popular references to the moving average crossover is when the 50 day EMA crosses over the 200 EMA and is known as the ‘golden cross’ - a strongly bullish signal. Likewise, the ‘death cross’ occurs when the 50 day EMA crossed under the 200 and is seen as very bearish.

Moving average levels

Crossovers are probably the most common method used by traders, however, there are other uses for moving averages in trend following. Some traders, for example, will enter a long position when the price jumps above just one moving average. They will then exit when the price drops back below the MA. Using the chart above as an example, a trader would therefore buy the market as it jumped above the 20 day MA on 1 Jan 2013. He would then close the position when the market dropped back below the MA on 19 February, making a substantial profit.

As well as this, moving averages can also be used as a guide for placing stops or as confirmation signals for other trend following strategies. The combinations are seemingly endless.

Williams Percent Range Oscillator

Unlike the moving average, which is most commonly used to spot the beginning and end of a trend, the Williams Percent Range (WPR) indicator is an overbought/ oversold oscillator more associated with the strategy of mean reversion.

Essentially, the WPR oscillator works rather like the relative strength index (RSI) or Stochastic Oscillator. Developed by Larry Williams, WPR, uses a scale of values that fluctuate between 0 (strongly overbought) and -100 (strongly oversold) to indicate the overall condition of the market. The oscillator is calculated using a combination of the current closing price, the lowest low of a certain number of periods and the highest high of the same number of periods. It can be worked out as follows:

First, choose a period “N” for “%R” (eg. 14);

Then, use the formula:

%R = 100 * (HN – CCP)/(HN – LN) where CCP = Current Closing Price, LN = lowest low of past “N” periods, HN = highest high of past “N” periods;

Interpretation

Understanding the WPR oscillator is pretty easy. Basically, whenever the oscillator is between the values 0 and -20, the market is overbought. In such a condition, a trader should be very cautious about buying the market, and should consider closing his position if long.

Likewise, whenever the oscillator is between -80 and -100, the market is oversold and represents a good opportunity to buy the market.

As can be seen from the chart below, the WPR oscillator often has an uncanny ability for showing the turning points in the market.

Of course, no technical indicator is foolproof and using both the WPR oscillator and moving average techniques will occasionally lead to false trends or reversals. That is the nature of trading.

However, by testing different settings and combining indicators together, it may be possible to find ways to harness the power of these trading tools and reap the rewards.


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