When folks talk about the latest “wonder” indicator they just saw their hero using, I ask them to explain to me (at least in general) how the indicator is calculated, so that we can understand what to expect of it and what its limitations are. This leaves them speechless an alarming amount of the time.
The majority of indicators are fairly straightforward to construct, requiring at most some basic Excel skills. And in general, the more esoteric an indicator’s calculation becomes, the less useful that indicator is in the real world… which is nice for us country boys.
When it comes to Technical Analysis, moving averages are the most-frequently used indicators around. This also makes them some of the most misused indicators around, since they’re an easy target for the Fortune Tellers and Village Idiots who often masquerade as technical analysts.
Happily, moving averages are very straightforward to construct and understand, enabling us to use them productively as the tools they are, instead of mistaking them for the voodoo magic some would have us believe TA to be.
First, let’s define what a moving average is:
A moving average is a curve plotted by linking a series of points, each of which is the average of the closing prices of a certain number of preceeding bars. For instance, each point in a 10-bar moving average would be the average of the prior 10 bars’ prices.
The number of bars used in the calculation is also known as the number of periods. A 10-bar moving average and a 10-period moving average are synonymous. If you see a reference to days, such as in a 50-day moving average, that’s simply a 50-bar moving average based on daily bars. In addition to daily bars, there are monthly bars, weekly bars, 60-minute bars, 3-minute bars… the variety is endless.
Constructing Moving Averages
To construct a 10-bar moving average, first get yourself a list of historical prices. Daily data is the easiest to find. My personal favorite source for historical data is Yahoo Finance historical quotes.
Pick a starting point, then take the closing prices of the previous 10 bars and average them (add them together and divide by 10 in this case).
Repeat the same calculation for the data ending with the next bar, then the next, and so on. As you do, the average will change slowly, or “move.” Hence the term moving average.
Repeating this calculation for multiple bars and graphing the results (connecting the dots) will give you the pretty curve we’re all used to seeing on our charts.
A basic spreadsheet makes life oh-so-much easier, and Yahoo! and other good sources allow you to download many years’ worth of data directly into a spreadsheet-readable table.
What Moving Averages Show Us
At any given point, a moving average shows us the average price of the last “n” bars, nothing more. Nothing more! It is imperative that we keep this fact in mind when making trading decisions.
What is the advantage of knowing the average price of a range of bars? For the given period, it’s the price area nearest a proportionately large number of that period’s trades. That is, it’s the area where the fewest people have extreme gains or losses for the period (remember we may be talking about just a few bars as the period, and the term “extreme” is relative), and pressure to trade (out of fear or greed) tends to diminish.
This is also known as an area of support or resistance, where the buying (or selling) from the extremes subsides as price approaches the average.
Finally, as the price reaches equilibrium, this is the area where it becomes more probable for the pressure that caused the price to move away from the average in the first place (rumors, news, “they say”) to reassert itself, causing a new thrust in the original direction. That’s where we come in. The resumption of a trend away from the average can provide us with a low-risk entry point into our trade.
The significance of this phenomenon varies with the stock and the period of the moving average. In some cases it may seem almost “magical” (but it’s not!) how the price retraces to the average, then resumes its thrust. In others, the average of a given period is entirely useless.
Which Moving Average Period to Use
I’m gonna say it. I’ve got to. It Depends. Selecting a moving average which gives us useful results can be very tedious. A randomly-selected moving average often will do very little towards identifying significant areas of support and resistance, and what’s worse, the pretty picture it makes can easily fool our dragons-in-the-clouds brains into thinking we see something which isn’t there. In that way, our efforts can actually make our trading results worse than those of pure chance. Beware.
The good news is that for most stocks, a properly-selected MA can be a very valuable aid. As well, some moving averages are almost universally applicable. The famous 50-day and 200-day moving averages will usually clearly identify ranges of support and resistance. I believe this is attributable at least as much to the phenomenon of “it works because everyone uses it” as it is to “everyone uses it because it works.”
The popluarity of these major averages is also the source of the old trader’s axiom “never sell down into the 200 or buy up into it”. In other words, don’t short into almost certain support and don’t buy into almost certain resistance. We’re trying to stay on the correct side of probability, remember!
Various moving averages also seem to be useful in certain limited situations. Whether because they identify support and resistance, or that they just act as a visual filter to clarify price overextension is hard to say, but they’re useful nonetheless. Examples include the 5-bar MA and the 34-bar MA which many daytraders find helpful.
The best practice is to do your homework. Find which MAs have identified support and resitance on which stocks and in which situations in the past. Then try applying them in real-time and see if they are of use. I bet you’ll be pleasantly surprised.
Variations on Simple Moving Averages
There sometimes seem to be as many variations on the Simple Moving Average (SMA) as there are traders to use them. I’ll just mention a few in passing here:
Exponential Moving Average (EMA) - Almost as common as the SMA; based on a calculation which gives more weight to the value of recent data. In a 10-period EMA, for example, the most recent bar’s value would figure more heavily in the calculation of the average than the 5th or 6th bar back. This results in a curve which follows all the bars’ data, but is “faster” at responding to price changes than an SMA.
Multiple Moving Averages (MMAs) - this is a technique of overlaying, you guessed it, Multiple Moving Averages on the same chart. Some folks use this technique to spot likely areas of support and resistance as the price and the averages converge. Different people use different combinations of SMAs and EMAs with various time periods. The formations these multiple averages make on a chart include names like “rainbows” and “bowties” for obvious reasons.
Different Source Data - Many charting packages allow us to use something other than the closing price of our bars in calculating moving averages. For example, one program I use lets me choose among using the closing price, the average of each bar’s high and low, or the average of the bar’s open and close. These settings are interesting to doodle with, and in certain circumstances (i.e. exremely wide-ranging or erratic bars) may yield a more useful curve than basing the calcs off of closing prices alone.
What Moving Averages Don’t Show Us
We often hear (or say) things like, “The price found support at the moving average and resumed its uptrend.” A characterization like this is akin to one like, “The sun rises in the morning and sets in the evening.” That is to say, it provides a satisfactory description of what appears to be happening. It’s perfectly acceptable to use such a characterization, and we can even make some assumptions about future probabilities based on it, as long as we know it’s a figure of speech and not literally the truth.
The moment we actually begin to believe that the sun really is sinking, and racing around to come up behind us again is the moment we start making some outrageous, erroneous assumptions, and even more outrageous proclamations, like perhaps that the laws of physics are invalid, or the earth is flat.
Likewise, if we actually believe that “price” is some sort of entity which gives a flying flip where “the 50″ is, and therefore it will, it must, go here or there or do anything, we’re in no-man’s land with the astrologers and the message-board hysterics. We begin to think we can divine the future. Knowingly or not, we become perpetuaters of the hocus-pocus form of technical analysis.
It is extremely important that, regardless of the terminology we use, we recognize the moving average as useful but not magical.
An appropriately-selected indicator like a moving average can help us to locate price areas where probability lies on the side of a trend resumption (or on the side of a trend failure), improving our chances of positioning successfully and aiding us in placing our stops, and therefore clearly defining and limiting our risk for the times when we’re proven wrong. This type of analysis is indeed technical, and it’s entirely legitimate.