Moving averages are popular indicators that traders use to identify whether prices are moving up or down. When the closing price is above a moving average, prices are considered to be in an uptrend. A downtrend is defined when prices close below the moving average.
Some traders prefer to anticipate trend reversals and use indicators like the stochastics to find overbought and oversold price levels. The idea is that when prices are oversold, buyers should enter the market and push prices up. Selling is expected to increase after prices become overbought.
There are problems with any indicator and no system will ever be foolproof.
One problem with moving averages is that they will always be late. Prices can fall a great deal from a top before triggering a sell signal, and the bottom might be in place long before a buy signal is given. Using shorter moving averages can decrease the delay in the trade signal but usually increases the number of losing trades.
Overbought and oversold markets can stay at extremes for extended periods of time. Using unfiltered signals to enter trades can result in large losses when signals are early. There is also no guarantee a market will become overbought or oversold at the end of a trend, so there is the risk of missing trades or not getting an exit signal.
The Average Directional Index (ADX) is different than other indicators in that it never gives a "buy" or "sell" signal. This indicator is designed to determine only whether a market is trending.
Many traders interpret ADX differently, but I assume a market is trending when ADX is above 25. After spotting a rising ADX that crosses above 25, I look at the stochastics to determine whether the market is oversold. If it is, I have a buy.
Since this is a simple trading system, I used a simple exit strategy in testing. I simply closed the trade after it has been open for eight weeks. Testing with 35 different ETFs that include major U.S. indexes and international markets shows that this system would deliver winners 64.1% of the time. The average gain was twice the size of the average loss.
For comparison, buying the ETFs and holding them for a random eight-week stretch would have delivered winning trades 58.8% of the time, with the average win only 1.3 times as large as the average loss. So the strategy gives traders an edge, and it does so with less risk.
Right now, the system is giving a "buy" signal on iShares Latin America 40 Index (ILF).
This is a part of the world that hasn't really been in the news much. The fund's largest holdings are in Brazil and Mexico, with more than 51% of assets invested in Brazil and 27% in Mexico.
What news there is from Brazil seems to be negative, with the International Monetary Fund recently lowering its estimate of economic growth. But if Brazil meets expectations, it would grow at 3%, still faster than the developed economies in North America and Europe. Mexico is also expected to grow at about 3.5%.
Despite faster economic growth, the markets are trading at a discount to U.S. stocks. Brazil has a price-to-earnings (P/E) ratio of 13, and Mexico's is 15. ILF could be a bargain if growth meets expectations and P/E ratios rise.
The weekly chart shows that this is a relatively low-risk trade. ILF has been in a consolidation pattern that provides a price target of $47.74, about 11% above the current price, within three to six months. The risk can be managed with a stop-loss at $41, the lower edge of the pattern, which is about 4.5% below the current price.
With the possibility of a trend just beginning and a reward-to-risk ratio of almost 2.5-to-1, this trade could be appealing to conservative traders.
Recommended Trade Setup:
-- Buy ILF at $43 or less
-- Set stop-loss at $41
-- Set price target at $47.24 for a potential 11% gain in 3-6 months