If the market penetrates the trading range, options sellers are ex-
posed to great risks. Recall that sellers of options (as long as they do not
own the underlying stock) face a huge potential liability, a liability that
can be many times the premium that they collected upon sale of the op-
tion. When such unlimited losses loom, these option writers “run for
cover,” or buy back their options, accelerating the movement of prices.MOVING AVERAGES
Successful technical trading requires not only identifying the trend but,
more importantly, identifying when the trend is about to reverse. A pop-
ular tool for determining when the trend might change examines the re-
lationship between the current price and a moving average of past price
movements, a technique that goes back to at least the 1930s.^8
Amoving averageis simply the arithmetic average of a given num-
ber of past closing prices of a stock or index. For example, a 200-day
moving average is the average of the past 200 days’ closing prices. For
each new trading day, the oldest price is dropped and the most recent
price is added to compute the average.
Moving averages fluctuate far less than daily prices. When prices
are rising, the moving average trails the market and, technical analysts
claim, forms a support level for stock prices. When prices are falling, the
moving average is above current prices and forms a resistance level. An-
alysts claim that a moving average allows investors to identify the basic
market trend without being distracted by the day-to-day volatility of the
market. When prices penetrate the moving average, this indicates that
powerful underlying forces are signaling a reversal of the basic trend.
The most popular moving average uses prices for the past 200 trad-
ing days, and it is therefore called the 200-day moving average. It is fre-
quently plotted in newspapers and investment letters as a key
determinant of investment trends. One of the early supporters of this
strategy was William Gordon, who indicated that, over the period from
1897 to 1967, buying stocks when the Dow broke above the moving av-
erage produced nearly seven times the return as buying when the Dow
broke below the average.^9 Colby and Meyers claim that for the UnitedCHAPTER 17 Technical Analysis and Investing with the Trend 295
(^8) See William Brock, Josef Lakonishok, and Blake LeBaron, “Simple Technical Trading Rules and the
Stochastic Properties of Stock Returns,” Journal of Finance, vol. 47, no. 5 (December 1992), pp.
1731–1764. The first definitive analysis of moving averages comes from a book by H. M. Gartley,
Profits in the Stock Market, New York: H. M. Gartley, 1930.
(^9) William Gordon, The Stock Market Indicators, Palisades, N.J.: Investors Press, 1968.