Module 6 – Moving Averages

Introduction

The moving average is one of the most widely used indicators in the realm of technical analysis. As you will learn from studying this module, it is also one of the most versatile, and many traders do not appreciate the many different ways in which they can apply it to maximize their profits. However, because it’s so easy to understand and construct, it does form the basis of many trading systems.

The first thing to note is that the moving average is unambiguous, whichever type you choose, so you can rigorously back test any system that uses it. This is in contrast to pattern recognition, where different experts may vary on their opinion of what constitutes a triangle or wedge, or whether the volume is sufficient to confirm the validity of the pattern. So creating mechanical systems using moving averages is fairly easy, and you can concentrate on refining the details for maximum profit.

‘The’ moving average is actually a whole host or family of figures and lines. There are different types of moving average, and each type can be constructed as a whole set with different periods. Some types of moving average are better in certain tasks than others, and you are free to experiment and find the type and values which work best for your trading. I’ll give you the generally accepted values here, so you can start with them, but if you want feel free to ‘tweak’ them to see if you can get better results.

Simple Moving Average

I think everyone knows what an average is – it’s a set of numbers, all added together and then divided by the number of numbers. So the average of the numbers 1, 2, 4, 6, and 7 would be 4 – that is the sum of the numbers, which is 20, divided by the number of numbers, which is five. You can do this for any set of numbers, and it’s called the arithmetical or simple average of those numbers.

In trading, the basic type of simple average used is called the simple moving average because the value changes or moves every day and we draw a line connecting the values. The value on any particular day is the sum of the prices on the previous x days divided by x. So in the families of moving averages you already have the choice of any x. Here’s a sample chart where x is 10, so the simple moving average is referred to as SMA(10), and is the red line shadowing the prices.

By the way, I’m using the daily charts here as that is most common, but of course you can use moving averages on intraday charts, weekly charts, whatever you want.

Now because the average is based on prices that go back so many days, it is called a lagging indicator. Its value must always follow any market action, and can’t anticipate it. The 10 day moving average hugs the price fairly closely, and a longer-term average would give a smoother line, at times further away. In effect, the moving average smoothes out the price information, so one basic use of it is to confirm the direction of the trend, up or down.

You can see in the chart that the moving average turns down a few days after the price turns down, and similarly lags when the price turns up — as you would expect. You might notice something else, too – the moving average is acting almost like a trendline, except that it is curving to follow the price. This is one way it can be used, as I’ll explain later.

Now to try and make the average line more relevant to the current price, traders have put together other ways of calculating the ‘average’. These are not so much averages as data manipulation based on a set of prices, but that’s what they’re called. The next most commonly used average is the exponential moving average (EMA), explained in the next section, and you can also find the triangular moving average, which applies more significance or weight to prices in the middle of the time period; the variable moving average, which changes the price weighting based on price volatility; and the weighted moving average, which applies more weight to the nearer prices. These and others have all been devised to overcome perceived limitations, particularly to try and reduce the lag effect.

Moving averages are relatively simple to understand and straightforward to use since most charting software packages will include them as standard. The main limitation is that they are lagging indicators and thereby require careful handling if you are actually going to make any money out of them.

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