Using Moving Averages Effectively – Part 1

One observable market fact is that prices are pretty much random. Random in trends; random in changes. No surprise, then, a best-selling market book is called ‘A Random Walk Down Wall Street.’

Such randomness makes financial prices notoriously ‘noisy’. It makes markets harder to read and trading much more difficult. So much so that any analytical tools that can reveal, track, or determine price trends becomes immensely popular. One such tool is the moving average.

In its simplest form, a moving average is just a running sum of prices divided by a number (the ‘parameter’ M). The most popular parameters are 50, 150 or 200. Simply, a moving average smooths prices; follows the price trend; and create reference points for visual analysis.

How ‘smooth’ a moving average depends on the parameter M. Generally, a larger M equals a smoother moving average. So a smaller M = a noisier moving average.  If M = 1, then it becomes the actual price – and will be meaningless.

How exactly does one use a moving average? Many ways. For example:

  1. Trend determination. If prices are higher than a long-term moving average (MA), the stock is said to be in an uptrend. If prices are below the MA, the stock is in a downtrend. We can, for example, use this to separate stocks within a universe into bullish and bearish camps.
    • Uptrend = Prices above MA
    • Downtrend = Prices below MA
  2. Trading signals. If a stock is in an uptrend, buy. If a stock is in a downtrend, sell.
  3. Contrarian reference. If a stock is significantly above its long-term MA – say 20% – label it ‘risky’. Stop trading the instrument as it is vulnerable to a sharp correction back to its long-term MA.
  4. MA as support and resistance. A long-term MA often acts as support or resistance during a trending phase. (see last week’s piece on S/R)

How good is a moving average? To some, they are indispensable. Because it is a widely-used indicator, easy to compute, and reasonably useful, many variations of the MA have been devised. One such variation is the so-called Golden Cross – a cross generated when an instrument’s 50-day MA crosses the 200-day MA from below.

Note that since the long-term MA of major stock indices is a closely watched indicator, it can create a self-reinforcing loop.

Application – Nasdaq Composite

To show how a moving average can be used, let’s take a look at the Nasdaq Composite Index (featured above). Since mid-2016, prices have been traded consistently above its 200-day MA. So any investor who took the buy signal in Jun ’16 and long IXIC would be in-the-money. [MA as buying signal]

Nasdaq’s smooth uptrend lasted for some months. But the moment prices accelerated away from the MA, eg in January this year, the index was slammed back down to the indicator shortly after. [MA as a contrarian indicator]

More remarkably, the index’s correction paused right at the 200-day MA. Prices bounced off this MA several times before picking up upward momentum again to new all-time highs. [MA as technical support]

What more can you ask from an indicator?

Of course, during a trendless, sideways range, a MA is less likely to do well. Simply because prices are meandering sideways, cutting through the MA several times from above or below, without leading to any meaningful trends. ‘Whipsaw’ is what traders call this phenomenon. To prevent such whipsaws from decimating your equity account, make sure each trade is small enough as not to cause too much damage to the overall portfolio if it goes awry. Also, you might want to look MA filters before deciding on a trade.

Conclusion

Trading is a tough game. Any indicator that could give you an edge should reused and incorporated into your analysis. In this respect, a moving average is an extremely useful tool that should be investigated thoroughly by traders. Indeed it has. But how to use it in your actual portfolio decision will depend on your preferences. Once the setup is tested and done, you can run the analysis/trading on an auto-pilot mode – and free up your time for other things.

Ten things to understand before you start trading…

1.    How to use support and resistance levels in trading
2.   Using Moving Averages Effectively – Part 1
2.5 Using Moving Averages Effectively – Part 2
3.   Momentum indicators and trends change
4.   Understanding Price Breakouts and its Significance
5.   Q&A On Price Patterns With Jackson Wong PhD
6.   The Importance of Group Analysis
7.   Three Chart Characteristics That Precede A Trend Change
8.   Thoughts on trading the market via Breadth
9.   Six Market Trends and Trading Signals to Look For Outside Individual Price Action
10. The Key To Long-Term Investment Success – Know Yourself…

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