Moving Averages

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Introduction

One of the reasons that is technical analysis is not universally accepted as by many fundamentally based traders is due to subjectivity involved in chart patterns. One tool that is widely used by both technicians and fundamental traders is the moving average. Moving averages are popular tools for trend following strategies which often require the elimination of subjectivity found in most technical indicators. Moving averages are used to smooth price data to create trend following systems. For most traders, moving averages are easy to calculate and versatile enough to use in many different strategies. The three most common types of moving average are: simple, exponential and linear. The simplest to calculate and one of the most popular is the simple moving average (SMA).

Formula

A simple moving average is typically calculated by taking the closing price of a stock over a specific number of trading period and summing them up and dividing the sum by number of periods. To calculate a 10-day simple moving average we take the sum of closing prices for the last 10 periods and divided by 10. With all moving averages, the next day’s value is calculated the same way expect we add the next day and drop off the oldest period. This will allow the average to move along with time. Below is an example of a 10-day moving average evolving over three days.

Daily Closing Prices: 1, 2, 3, 4, 5, 6, 7, 8, 9, 10

First day of 10-day SMA: (1 + 2 + 3 + 4 + 5 + 6 +8 + 9+ 10) / 10 =5.5

Second day of 10-day SMA: (2 +3+ 4 + 5 + 6+ 7+ 9 +10 +15) / 10 = 6.9

Third day of 10-day SMA: (3+ 4 + 5 + 6+ 7+ 9 +10 +15+20) / 10 = 8.7

SMA= 5.5, 6.9, 8.7

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Interpretation

The important to understand is that the each calculation is simple the average price for a specific time period. By monitoring the behaviour of the average prices, analysts look to identify any trends in the data. Note in the data above as the closing prices are rising the average price is behind or “lagging” behind the last calculation. This is called the lag factor of the moving average. The lag factor is referred to as the sensitivity of the moving average. The longer the moving average period, the longer the moving average will lag behind the most recent data. So the longer the time period of the SMA the less sensitive the moving average will be relative to a shorter moving average.

Lengths and Timeframes

One subjective decision that traders and analyst cannot avoid is deciding what time period should be used to calculate the moving average. Most traders will use short term moving averages identify short-term trends for trading. Typical 5 to 20 periods are used to calculate short term SMA’s. Analysts tend to be more concerned identifying secular trends that are usually medium-term trends. Medium term trends can be identified by SMA with 20-60 periods. The 50-day moving average is the popular for analysing medium-term trends. Long-term trends can be identified by analyst using moving averages with 100 or more periods. The 200-day moving average is the most popular for identifying long term trends.

Trend Identification

The most basic use of a moving average is that it allows traders and analyst to make quick and visual identification of trend direction. The most common way is compare the last market price to a moving average of choice. If the last price is above the SMA then the trend is considered upward and if the last price is below the moving average then the trend is considered downward. By observing the direction of the moving average we know that a rising moving average means that prices are increasing. Conversely when we see a falling moving average, we know that prices are decreasing.

Many traders will use different SMA periods to determine if prices are trending in unison. For example one trader may determine that a 10 period SMA will determine the short term trend, and the 50 period SMA will determine the intermediate trend and the 200 period will represent the long term trend. If prices are above all the time periods a trader will have more confidence trading from the long side and will be reminded not to trade against the trend. If one or more of the time period are not in agreement a trader may decide to either wait prices to be above or below all of the SMA’s to trade or maybe take a very short term low risk trade.

Moving averages often act as support in an uptrend and resistance in a downtrend. Traders will look to add long positions on market pullbacks and short positions during bear rallies. It is important to point out one should never expect that moving averages create exact points of support and resistance. More appropriately moving averages should be viewed as levels of support and resistance.

Some of the earliest mechanical trading systems have incorporated moving average crossovers as part of their strategies. These systems use simple price crossovers to generate buy and sell signals. A buy signal is generated when the market price closes above a SMA. A sell signal is triggered when market prices close below the SMA.

Double Crossovers

The double crossover uses two moving averages to generate buy and sell signals. The double crossovers uses two moving averages where one moving average is a short term moving average and the other is a long term moving average. A bullish signal known as the golden cross occurs when the shorter moving average crosses above the longer moving average. Bearish sell signal is called the dead cross and occurs when the shorter moving average crosses below the longer moving average.

Moving average crossover systems tend to create many false signals when used in markets that not trending strongly. To reduce the amount of false signals some traders added an additional moving average. In a triple crossover system, three moving averages are used and buy and sell signals are generated when the shortest moving average crosses the two longer moving averages.

Conclusion

Moving Averages are great tools for traders and analysts to have in their arsenal. One reason for the appeal of moving averages is that they are simple enough and easy to calculate. Traders and analyst can use SMA’s to quickly identify trend direction. Another reason for the appeal is that SMA’s can easily used to identify levels of support, resistance, or create buy and sell signals. Interestingly enough, moving averages are also versatile enough to be incorporated in elaborate trend following system too. As with most technical analysis tools, moving averages should not be used on their own, but in conjunction with other complementary tools.