Moving Averages and R-Zones

Bob Iaccino, Chief Market Strategist and Co-Founder of Path Trading Partners, joins us live every Thursday from 11 AM ET, as our risk management educator.

With 30 years' experience working as an active investor in equities, commodities, futures and FX, there are few better to talk on the subject of risk management.

Bob has developed a method for breaking down his key fundamentals of risk management in a way that he thinks retail traders can understand and use to get actionable insights to bring into their own trading.

Below are some excerpts of Bob’s thoughts from a recent live session.

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How Do Moving Averages Show a Trend?

Moving averages are lagging indicators and do not predict new trends. It's very important to remember that while they don't forecast trends, they can help confirm trends after they have been established. A market is in an uptrend when the current price action is above a moving average, and the slope of the average is sloping upward. Conversely, a market is in a downtrend when the current price action is below the moving average, and the slope of the average is sloping downward.

This may seem obvious, but it’s crucial to view it this way. It’s the combination of both factors that confirms the market is in a trend.

Since moving averages lag behind current price action, it takes longer for the average to turn. Thus, the confirmation of a trend change indicated by the moving average is not solely dependent on the price being above or below the average.

In other words, if you have a flat moving average, it doesn't provide useful information.

Moving Averages as Support and Resistance

Widely used moving averages like the 10, 20, 50, and 200 generally provide the best support and resistance. Why? Because they are widely used.

This effectiveness is partly due to a self-fulfilling prophecy, which is why the more popular moving averages consistently provide the best support and resistance locations.

Support and resistance are easily visible on a chart. However, too many traders treat moving averages as exact prices for support or resistance. In reality, moving averages should be treated as areas where prices might overshoot or undershoot.

See this example of a 20-period exponential moving average providing support and resistance to price action. You can see it provides it on the left. It’s providing support in the middle of this chart, but breaking through it constantly. Then as you move to the right, it provides good support, breaks it again, but still provides support.

These are areas, not absolute brick wall stock prices.

What is the R-Zone?

Prices do not travel in straight lines but form a series of waves or rotations. Many people study Elliott Wave theory for this reason. These rotations often produce swings, which in turn produce chart patterns and trendlines. Areas where rotations are likely to happen are called the R-Zone or the rotation zone. In this context, R stands for rotation.

In the above example, each one of those arrows' points to somewhere where a price moved into an area between two key moving averages and then held up. There're still breaks, but you're getting a zone instead of just a flat price.

When you're using one moving average and saying this is where it's going to stop, or, worse yet, this is where I'm going to place my stop, you're going to be disappointed.?

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What is the Moving Average R-Zone?

Moving averages are dynamic significant levels. By combining two moving averages, a zone or space is created between them that expands and contracts with price action.

At some point, the moving averages will cross and start to separate, producing a potential rotation zone. Future price action may pull back into that zone, find support or resistance, and resume its original direction. This is where trades can be found. Moving averages represent price areas rather than exact levels.

Some traders expect prices to stop directly at moving averages and use them as stop areas, but this approach can be disappointing. Moving averages provide areas where price can react rather than exact stopping points.

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What Moving Averages Do We Use to Form an R-Zone?

We use exponential moving averages (EMAs) instead of simple moving averages (SMAs). EMAs are weighted so that the most recent candlestick has a greater impact on the moving average than past candlesticks.

Our rotation zone is constructed with the 8-period and the 21-period exponential moving averages. The rationale for using EMAs is that recent price action carries more weight than older price action, as markets have short memories and react more aggressively to recent events.

In our rotation zone, we use an 8-period and a 21-period EMA, matching the period of the chart being analyzed. Additionally, we include the 50-period EMA and the 200-period SMA.

What Are Dynamic Significant Levels?

The 8, 21, and 50-period moving averages are considered dynamic significant levels because of the price action tendencies that form around them, similar to traditional significant levels.

You get emotional candles, which are either big colored candles, red or green, or they have massive wicks.

You get tails at or near these averages. The massive wicks that I referred to, happen at or near these averages more often than not.

Candles seem to either run away or breakthrough these averages aggressively.

Moving Average Rotation Zones and Time Frames

Rotation zones on higher time frames are more significant than those on lower time frames. For example, a rotation zone on a daily chart is more significant than one on a 4-hour chart, which in turn is more significant than on a 60-minute chart.

Trending Price Action and Moving Average Rotation Zones

Moving average rotation zones are significant when the market is trending. The stronger the trend, the more significant the rotation zone on shorter-term charts.

A very strong trending market might respect the rotation zone on the f5 or the 15-minute chart and not pullback enough to enter a rotation zone on a 60-minute chart. So, when you're in these trends, you want to scalp in the direction of the trends, not the opposite direction and you could use R-Zones on shorter-term charts for the same reason.?

When a market enters an extended period of consolidation or congestion, moving averages will converge and go flat, centered around the middle of the congestion. During this phase, the rotation zone loses its relevance, and we wait for the market to exit the congestion before it becomes significant again.

The easiest way to see this is when the market forms a horizontal channel price congestion. Another sign is that the market is in congestion or consolidation and that the moving averages will also cross back and forth repeatedly.?

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