Exponential Moving Average vs. Simple Moving Average: An Overview
Exponential Moving Average (EMA) and Simple Moving Average (SMA) are similar in that they each measure trends. The two averages are also similar because they are interpreted in the same manner and are both commonly used by technical traders to smooth out price fluctuations.
There are some differences between the two measurements, however. The primary difference between an EMA and an SMA is the sensitivity each one shows to changes in the data used in its calculation.
SMA calculates the average of price data, while EMA gives more weight to current data. The newest price data will impact the moving average more, with older price data having a lesser impact.
More specifically, the exponential moving average gives a higher weighting to recent prices, while the simple moving average assigns equal weighting to all values.
Exponential Moving Average
Since EMAs place a higher weighting on recent data than on older data, they are more reactive to the latest price changes than SMAs are, which makes the results from EMAs more timely and explains why the EMA is the preferred average among many traders.
As shown in the example below, traders with a short-term perspective may not care about which average is used, since the difference between the two averages is usually a matter of mere cents. On the other hand, traders with a longer-term perspective should give more consideration to the average they use because the values can vary by a few dollars, which is enough of a price difference to ultimately prove influential on realized returns, especially when you are trading a large quantity of stock.
As with all technical indicators, there is no one type of average a trader can use to guarantee success.
Simple Moving Average
The SMA is the most common type of average used by technical analysts and is calculated by dividing the sum of a set of prices by the total number of prices found in the series. For example, a seven-period moving average can be calculated by adding the following seven prices together and dividing the result by seven (the result is also known as an arithmetic mean average).
Example Given the following series of prices: $10, $11, $12, $16, $17, $19, $20 The SMA calculation would look like this: $10+$11+$12+$16+$17+$19+$20 = $105 7-period SMA = $105/7 = 15
Moving averages are fundamental to many technical analysis strategies, but successful traders use a combination of techniques. Investopedia’s Technical Analysis Course will show you how to identify patterns, signals, and technical indicators that drive the behavior of stock prices with over five hours of on-demand video, exercises, and interactive content.
Key Takeaways
The exponential moving average gives a higher weighting to recent prices.
The simple moving average assigns an equal weighting to all values.
As with all technical indicators, there is no one type of average a trader can use to guarantee success.
The rectangle is a classical technical analysis pattern described by horizontal lines showing significant support and resistance. It can be successfully traded by buying at support and selling at resistance or by waiting for a breakout from the formation and using the measuring principle.
Key Takeaways
A rectangle occurs when the price is moving between horizontal support and resistance levels.
The pattern indicates there is no trend, as the price moves up and down between support and resistance.
The rectangle ends when there is a breakout, and the price moves out of the rectangle.
Some traders like to trade the rectangles, buying near the bottom and selling or shorting near the top, while others prefer to wait for breakouts.
The Rectangle in Classical Technical Analysis
The rectangle formation is an example of a “price pattern” in technical analysis. Price patterns derive from the work of Richard Schabaker, considered the father of technical analysis, and Edwards and Magee, who wrote what many consider the bible on the subject.
This period of technical analysis derives from a time when charts were kept by hand on graph paper and even simple moving averages (SMA) had to be maintained by hand or with the use of a large, clunky adding machine.
Rather than modern technical analysis, which relies on indicators, such as moving average convergence divergence (MACD), technical analysts assumed that price patterns repeat themselves over and over throughout time. Pattern recognition meant pattern prediction and thus trading profit.
Many of the price patterns are based on geometrical figures. There are ascending, descending and symmetrical triangles, pennants and wedges. Occasionally, more fancifulshapes are seen, such as the head-and-shoulders formation.
The Rectangle: Supply and Demand in Balance
A price chart or graph may be thought of as an X-ray of supply and demand. Figure 1 describes a rectangle pattern where supply and demand are in approximate balance for an extended period of time. The shares move in a narrow range, hitting resistance at the rectangle’s top and finding support at its bottom. The rectangle can occur over a protracted period of time or form quickly amid a relatively wide-ranging series of bounded fluctuations. Schabaker notes that it can approach a square in its proportions.
In any case, it is a pattern which shows trader indecision, one in which the bulls and bears are approximately equally powerful.
Figure 1.
Most technicians agree, the rectangle can serve as either a reversal or continuation formation. As a reversal pattern, it ends a trend either up or down. As a continuation pattern, it signifies a pause in the prevailing trend, with the expectation that the prior trend will eventually resume. In either case, the rectangle shows a tug of war between buyers and sellers. Ultimately, either accumulation or distribution prevails, and the shares breakout or breakdown.
“Significant” Support and Resistance
The concepts of support and resistance are critical to understanding the rectangle formation.
Support is defined as any price point below the current market price where buying should emerge to create, at least temporarily, a pause in a downtrend.
Resistance, on the other hand, is any price above the current market price where selling should emerge to create, at least temporarily, a pause in an uptrend.
In a rectangle, what may be referred to as “significant” support or resistance emerges – that is, a price level returned to again and again. Whereas trendlines in technical analysis are typically drawn on a diagonal, the diagramming of support and resistance requires horizontal trendlines.
ImClone Systems: an Example of a Rectangle Formation
Figure 2 of ImClone Systems (IMCL) employs open-high-low-close bars (rather than candlesticks) and is absent of any indicators, such as MACD. The only addition is a 30-week moving average (MA), which could have been calculated in the classical era.
Figure 2.
Several observations are worth making on this chart. First, note that an intermediate uptrend line, in force for approximately one year, is broken. The break shows the uptrend has ended. Thus, the prolonged rectangle can either be a reversal or consolidation formation. Until there is a breakdown or breakout from the confines of the rectangle – roughly $37.50 to $47.50 – the pattern’s interpretation is uncertain.
Second, horizontal lines drawn on the chart denote significant support and resistance. Significant support was first established in September, tested twice in the early part of the year and retested in June. At each test of support, there was sufficient buying interest to drive the stock higher.
Significant resistance at $47.50 was first touched in August, then probed in October, April and July. At each juncture, the sellers overwhelmed buyers, and the stock receded. This vacillation between significant support and resistance creates the rectangle shape.
One final observation is the slope of the 30-week MA. Of all moving averages, this may best describe the trend. It relates to the rectangle by showing the sideways nature of the formation. In an uptrend or downtrend, the 30-week MA will slope up or down, not sideways. Note how in the early stages of the chart it sloped higher, mimicking the uptrend. Later it flattened and began to slope sideways, showing the prolonged consolidation.
Trading the Rectangle
The following are two basic strategies for trading a rectangle:
The first is to buy at support and sell at resistance (one can also sell short at resistance and cover the short sale at support). To mitigate risk, in case the stock breaks down from support, a very tight stop can be employed of perhaps 3%. For example, if one bought ImClone at $37.50, the stop-loss would be 3% lower than $37.50 or $1.12. The trader would exit the position if the stock hit $36.38 ($37.50-$1.12).
Another method to trade the rectangle is to wait for the breakout. As with all technical patterns, this breakout should ideally occur on above-normal volume. To know when to consider exiting the trade, the trader could use the measuring principle described below.
The Measuring Principle
The measuring principle allows you to set a specific minimum price target. Such a target should give you the objectivity to hold during periods of minor countertrend movement.
The measuring principle works with any well-defined technical analysis pattern, such as a rectangle or triangle. To calculate the minimum target, first establish the height of the pattern. In the case of ImClone Systems Figure 3 shows the calculation as follows:
Top:
$47.50
Bottom:
$37.50
Height:
10.00 points
Figure 3.
For a bullish breakout, once the height of the pattern has been established, add the difference to the breakout level. Since the breakout level is $47.50 and the height 10 points, the minimum target is $57.50. Of course, it may take some time to reach the target, so the trader must be patient. As well, the measuring principle is a statement of probability, not a guarantee. The trader will carefully monitor the technical picture of the stock despite the target.
How was the rectangle in IMCL resolved? Bristol Myers Squibb bid $60 a share to acquire the 83% of ImClone it did not already own. Shareholders who had seen their stock go nowhere for a year, and saw the shares close at $46.44, woke up the next morning to find their stock had opened at $64.16, well beyond the minimum target set by the measuring principle. Those who traded the rectangle, in this case, turned out not to be “square.”
The Bottom Line
In summary, the rectangle is a classical technical analysis pattern bounded by significant support and resistance and described by horizontal trendlines. The pattern can be traded by buying at support and selling at resistance or buying the breakout and employing the measuring principle to set a target.
Candlestick patterns provide insight into price action at a glance. While the basic candlestick patterns may provide some insight into what the market is thinking, these simpler patterns often generate false signals because they are so common.
Below, we will look at more advanced candlestick patterns that offer a higher degree of reliability. These include the island reversal, hook reversal, three gaps and kicker patterns.
Island Reversal Pattern
Island reversals are strong short-term trend reversal signals. They are identified by a gap between a reversal candlestick and two candles on either side of it. Here is a bullish example. The price is moving down, gaps lower, then gaps up and continues higher.
Entry: The island reversal shows indecision and a battle between bulls and bears. This is often characterized by a long-ended doji candle that has high volume occurring after an extended trend. It is after the gap and move in the opposite direction that a trade is taken. For the bearish pattern, enter short after the gap and move in the opposite direction. For the bullish pattern, enter long after the gap and move in the opposite direction.
Exit: An exit refers to both the target and stop-loss. With this pattern, you want to capture the thrust in price that follows that pattern, but once that thrust starts to weaken, it is time to get out. If the price moves back to fill the gap, then the reversal pattern is invalidated, and you should exit right away. Therefore, a stop-loss can be placed in the gap or near the “island” candle.
Hook Reversal Pattern
Hook reversals are short- to medium-term reversal patterns. They are identified by a higher low and a lower high compared with the previous day. Here are bullish and bearish examples of the patterns.
Entry: On the bullish pattern, there is downtrend, followed by two up days. The first or second up day breaks the high of the last down day. It is the second up day when a long trade should be taken, as the pattern indicates that the price could continue to rally. For the bearish pattern, there is an uptrend, followed by two down days, and either the first or second down day breaks the low of the last up day. It is the second down day on which a short trade should be taken, as the pattern indicates the price could slide lower.
Exit: Know your exit points before trading this pattern.In most cases, you will see a sharp reversal, as shown in the chart above. Anything to the contrary indicates that the pattern is not working, so exit immediately. Therefore, a stop-loss can be placed above the recent high for a bearish pattern, or below the recent low for the bullish pattern. We can’t know how long the reversal will last based on the pattern alone. Therefore, maintain the trade for as long as the price is moving in the expected direction. When the move weakens or a pattern in the opposite direction occurs, take your profit.
San-Ku (Three Gaps) Pattern
The San-ku pattern is an anticipatory trend reversal signal. The pattern does not indicate an exact point of reversal. Rather, it indicates that a reversal is likely to occur in the near future. The pattern is created by three trading sessions in a row with gaps in between. While each candle doesn’t necessarily have to be large, usually at least two or three of the candles are.
Here is a three gaps pattern that signaled the end of an uptrend. The price is accelerating higher. There are three gaps higher in a row. Since such momentum can’t last forever, the buyers are eventually exhausted and price moves the other way.
Entry: This pattern operates on the premise that the price is likely to retreat after a sharp move because traders will start taking profits. For additional evidence of the possibility of a reversal, look for extremes in the relative strength index (RSI) or await a crossover of the moving average convergence divergence (MACD).
Exit: This pattern anticipates a reversal. If it doesn’t happen, get out of any trade that was taken because of this pattern. Price must follow through in the anticipated direction in order for the signal to be valid. Stop-loss orders can be placed above the high of the pattern if going short. Ride the downward momentum while it lasts. Since it is unknown how long the sell-off will last, take profits when you see a reversal signal in the opposite direction or when the selling momentum slows.
Kicker Pattern
The kicker pattern is one of the strongest and most reliable candlestick patterns. It is characterized by a very sharp reversal in price during the span of two candlesticks. In this example, the price is moving lower, and then the trend is reversed by a gap and large candle in the opposite direction. The first large green candle is the kicker candle. The second strong green candle shows the follow through of the powerful pattern and helps confirm that a reversal is in place.
Entry: This kind of price action tells you that one group of traders has overpowered the other and that a new trend is being established. Ideally, you should look for a gap between the first and second candles, along with high volume. Enter near the close of the kicker candle (first green candle in chart above) or near the open of the second candle.
Exit: Place a stop-loss below the low of the kicker candle. Because kicker candles can be so large, this may mean your stop-loss is a sizable distance away from your entry point. As for a target, this pattern often results in a strong trend change, which means that traders can ride the momentum of the kicker for a short-term trade, or even potentially a medium-term one, as the price could continue in the direction for some time.
Why These Patterns Work
All of these patterns are characterized by the price moving one way, and then candles in the opposite direction appear that significantly thrust into the prior trend. Such occurrences rattle the traders who were betting on the prior trend continuing, often forcing them out of their positions as their stop-loss levels are hit. This helps fuel a continued move in the new direction. This idea comes from a simpler candlestick concept called thrusting lines. For example, if there is an uptrend, if a down candle forms but stays within the upper half of the last upward candle, little damage is done to the trend. But if the down candle moves more than halfway down the last upward candle, then more than half the people who bought during that upward day are in a losing position, and that could lead to further selling.
The patterns above are even more powerful because the sharp change in direction leaves many people in losing positions that they need to get out of. Also, as traders spot the reversal, they jump into trades in the new direction. Both these factors – prior traders getting out and new traders getting in – help propel the price in the new direction.
All that said, attempting to trade reversals can be risky in any situation because you are trading against the prevailing trend. Keep the larger picture in mind. For example, during a strong multi-year uptrend, a reversal signal may indicate only a few days of selling before the bigger uptrend starts up again.
The Bottom Line
These advanced candlesticks are associated with strong price moves, and often gaps, which cause sharp shifts in direction. Traders can participate by noticing these patterns and acting quickly to get in as the price moves in the new direction. Candlestick patterns do not have price targets, which means traders shouldn’t get greedy. Ride the momentum for as long as it lasts, but get out if signs of trouble occur. Utilize stop-loss orders or a trailing stop-loss.
The iPath S&P 500 VIX Short-Term Futures (VXX) is an exchange-traded note (ETN) designed to provide investors with exposure to equity market volatility. Shares of an ETN, which is structured as a debt instrument, can be bought and sold like shares of stock.
During times of high volatility in the stock market, the value of VXX shares will typically increase. On the other hand, quiet periods for the market will likely keep shares trending lower. Here’s why.
Understanding VXX
The iPath S&P 500 VIX Short-Term Futures ETN is legally structured as an exchange-traded note (ETN), which is similar in nature to an exchange-traded fund (ETF). The main difference between an ETF and an ETN is that, while the exchange-traded fund represents ownership in a basket of securities—stocks, bonds, or commodities—within the fund’s portfolio, the exchange-traded note is an uncollateralized debt instrument and has bond-like characteristics: investors can hold shares until maturity (which is Jan. 23, 2048, for the VXX ETN launched Jan. 19, 2018) and buy and sell before maturity.
Key Takeaways
The iPath S&P 500 VIX Short-Term Futures ETN is an investment security that provides exposure to the volatility of the U.S. stock market.
An ETN is like an ETF, but rather than holding a basket of stocks, bonds, or commodities, the exchange-traded note is a debt instrument with a maturity date.
VXX is designed to track the value of futures contracts on Cboe Volatility Index, which is a gauge of current volatility that is priced into S&P 500 index options.
VXX continuously rolls VIX futures contracts at each expiration, which can detract from performance.
VXX shares will typically increase in value when market volatility increases, but trend lower when volatility is muted.
Managed by Barclays Capital Incorporated, the iPath S&P 500 VIX Short-Term Futures ETN is linked to the daily price changes in Cboe Volatility Index, but in a complicated way. VIX is sometimes called the market’s “fear gauge” because it tends to rise during periods of market uncertainty and spike in times of panic. The index tracks changes in the expected volatility priced into S&P 500 Index options and is computed using an options-pricing formula.
Futures contracts are listed on Cboe Volatility Index, and VXX is an ETN that tracks the S&P 500 VIX Short-Term Futures Total Return Index, which is designed to offer exposure to long positions in Cboe Volatility Index futures contracts. Therefore, VXX does not track VIX itself (spot VIX), but the futures on VIX, which often trade at very different price levels depending on the time to maturity.
Risks
Since VXX must roll its futures contracts to rebalance the fund to the later contract, the fund manager is forced to sell the futures contracts that are closest to their expiration dates and buy the next dated contracts, which is a process called rolling. Since longer-dated futures contracts are often at higher levels than shorter-dated ones (during normal market conditions), the rolling activity can result in losses (as the ETN is forced to sell the lower-valued contracts and buy the higher-priced contracts).
In extreme market conditions, when volatility spikes, short-term VIX futures contracts can trade at higher levels compared to longer-term ones and the situation is called backwardation. More often, however, VIX futures are in contango and longer-term contracts trade at higher prices compared to short-term ones.
The iPath S&P 500 VIX Short-Term Futures ETN can be influenced by many unpredictable factors, and the price of VXX can fluctuate substantially between now and the maturity date. Influential factors include prevailing market prices of the U.S. stock market, S&P 500 Index options prices, supply and demand for VXX, as well as economic, political, regulatory or judicial events, or changes to interest rate policies. Basically, anything that affects stock prices can also affect volatility and VXX shares.
The Bottom Line
An investment in VXX might be suitable for investors who want to hedge their portfolios against a market downturn and speculators who have a high risk tolerance. However, since the iPath S&P 500 VIX Short-Term Futures ETN is only composed of derivative contracts, individuals should understand the Cboe Volatility Index and VIX futures before investing or trading the exchange-traded note.
