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Seminar #2.
Moving averages are used to smooth out the market's up and down fluctuations within a trend. For instance, the following chart shows how a 21 day moving average smooths the daily ups and downs of the Dow without destroying the picture that the Dow is either in a rally or a correction.
In so doing, moving averages will usually provide support on brief pull-backs when the market is rising, and provide overhead resistance on brief rallies when the market is declining.
Moving averages can be constructed using any time frame. Generally speaking 21 day and 30 day moving averages are useful for measuring shorter intermediate term trends, while 10 week (shown in the chart below) and 13 week moving averages are useful for measuring longer intermediate term trends.
Two hundred day, or 40 week, moving averages (shown in the chart below) are the most helpful for measuring the long term primary trend of most markets and stocks.
Given the unusually one-sided market of the 1990s, the above charts primarily show the moving averages providing support for a rising market. Since there have been no important corrections or bear markets, they don't demonstrate how moving averages tend to provide overhead resistance for rallies in declining markets. Not even the downside breaks of the long term 200 day moving average resulted in serious corrections in the 1990s. So we've included the following chart which shows the market from 1963 to 1982, perhaps a more normal period, and how a break of the long term 40 week ( 200 day) m.a. has normally resulted in long term declines.
BREAKING THROUGH A MOVING AVERAGE:
Since a correctly chosen moving average usually provides support on pull-backs in a rising market, a break below the moving average obviously becomes a potentially important event. It may indicate a reversal in trend has begun. In the other direction, a break up through the moving average in a declining market is potentially important because it may indicate the down-trend has reversed to the upside.
The following chart of the NASDAQ, which has had more downside volatility than the Dow in the 1990s, shows more clearly the potential importance when a rising market breaks down through a key m.a., or when a declining market finally breaks back through a key m.a. to the upside.
WHAT IS A MOVING AVERAGE?
The term refers to the fact that a set of numbers is being averaged as the numbers move through time.
For instance, to begin calculating a 21-day moving average of AT&T, the closing prices of AT&T over the last 21 days would be added together, then divided by 21. That provides the average price at which AT&T sold over the last 21 days. That point would be marked on the chart today. To make the average move, each subsequent day the same process is repeated, and the new point is added to the chart. After a few weeks you have the 21-day moving average moving along the chart where its relationship to AT&T's price each day can be seen. Note that in calculating the m.a. each day, the oldest of the 21 closes is dropped and the new day's close is added (Only the prices over the most recent 21 days are added together and divided by 21 each day).
Of course to calculate a 10-week moving average you would continuously average the weekly closes for the preceding 10-weeks, and so forth.
Fortunately, if you have enough data regarding closing prices in your computer, the computer will perform the work and draw the m.a. in a split second.
TYPES OF MOVING AVERAGES:
The moving averages shown in the above charts and descriptions are known as 'simple' moving averages.
Numerous variations have been developed over the decades wherein 'weightings' are applied to the data (market closes) used in the calculations. The theory for some of them is that as a rally or correction moves along, its more recent action is of more relevance than the older activity. However, while weighted moving averages have their champions, there is little evidence that they're worth the extra effort. As in most endeavors, in technical analysis simple is rarely defeated by complexity.
However, you should be aware that there are 'weighted moving averages' in which a factor (of your choice) is added to the more recent closes used in the data, so the more recent data will have more effect on the level of the resulting moving average.
Another form of weighted moving average, the 'Exponential moving average', uses exponential smoothing as a means of adding more weight to the value of the most recent data. An exponential moving average is calculated by applying a percentage of today's closing price to yesterday's moving average value, and doing so on a continuous basis. The idea is that by doing so, more weight is given to recent market action and increasingly less to older data. To quote the example given in the Equis Metastock manual;
To calculate a 9% exponential m.a. of IBM: First, take today's closing price and multiply it by 9%. Then add this product to the value of yesterday's moving average multipled by 91% (100% - 9% = 91%).
M.A. = [(today's close) x 0.09] + [(yesterday's m.a.) x 0.91]
That is a very basic description. Technical analysis textbooks run to numerous pages just on moving averages.
Another school of thought favors "Triangular moving averages" which assign more weight to the middle portion of the data series.
THE VALUE OF MOVING AVERAGES:
Moving averages have considerable value, but it's not recommended that they be used alone to predict market direction.
As a careful comparison of the above charts show, the longer the time frame of the moving average the slower it is to respond to a trend reversal in either direction. That means that by the time one waits for the market or a stock to break through a slow (longer time frame) m.a. as an indication of a trend reversal, much of the move might already be made. On the other hand, the shorter the time frame of the moving average the quicker it responds to trend reversals. But, to respond to every break through a fast (short term) m.a. would result in numerous costly whipsaws.
Moving averages are most useful in predicting support levels when a rising market begins a pull-back potentially into a correction, or to predict overhead resistance levels when a declining market attempts to rally.
They're also useful in determining when a market or stock seems to be at an extreme either to the upside (so due for a fall), or to the downside (so due to rally). That determination is made by noting when the market or stock moves a greater distance from its m.a. in either direction than is normal. This judgment can be made visually, or actually measured by the number of standard deviations the market or index has deviated from the m.a. A close look at the charts provided above will clearly show that extreme deviations from the moving averages usually soon result in a dramatic move in the opposite direction.
Moving averages are also useful as one tool in determining whether a market or stock may have reversed its previous trend (by triggering an alarm when it breaks through a moving average).
COMING UP:
In the next seminar, we'll add to the usefulness of moving averages by adding trading 'envelopes' or trading 'bands' around them. Then we'll go on to variations of moving average crossover systems in which two moving averages are calculated, one slow, the other fast, with buy and sell signals actually triggered when one m.a. crosses over the other.