Today’s Trading Lesson From TradingMarkets

 

Figure 1. Simple Moving Average. The increase in the average from 78.20 to 82.80 was due, in part, to the older data being “dropped off”.

The drop-off concept is better illustrated in a “real world” example.
Referring to Ask Jeeves (ASKJ)
in Chart 2, notice that the moving average increased by 2.21 (a) while the stock
price actually decreased by 4 3/4 points (b). The fact that the moving average
increased even though the stock price decreased was due, in part, to the fact
that the older lower-level data was dropped off (c).

 

Chart 1 Ask Jeeves. The moving average continues to increase (a) even though the stock dropped in price (b). This is due to higher level prices being added to the average and lower level prices (c) being dropped off.

The drop-off characteristic is actually quite useful when trailing stops as
the moving average catches up to the price. However, when used as a gauge for
performance, this characteristic should be considered.

Reversion to the Mean

As I’ve joked in prior articles, if you know someone who’s mean but then nice
for a few days, chances are they’ll revert back to being mean. That’s the whole
concept behind reversion to the mean (average). Therefore, reversion to the mean
is simply a market’s tendency to revert back to average levels once stretched to
an extreme. Referring to Chart 2, December Bonds, notice that at points (a)
through (g) the market reverts back to the average after being stretched. The
problem is, you never know exactly how far “stretched” can be. Notice that at
points (f) and (g) the market moved to more extreme levels before correcting.
Nonetheless, the reversion to the mean characteristic is useful for determining
if a market is due for a correction.

 

Chart 2 December 1999 Bond Futures. Prices have a tendency to revert back to the mean (average). Notice that once stretched, points (a) through (g), the price tends to revert back to the average.

General Uses of Moving Averages

Now that we’ve defined the characteristics of moving averages, let’s look at
general ways to use them. Conventional wisdom states that you should buy a
market when the fast (short-term) moving average crosses above the slow
(longer-term) moving average and sell that market when the fast moving average
crosses below the slow moving average. Unless you’re fortunate to catch a market
right before a large trend (and subsequently quit following this “system”), you
will more than likely lose money with this approach *. This is illustrated in
chart 3, the cash S&P index. Notice that following this method would
occasionally catch a big trend (points (b) and (c)) but more often than not
you would lose money during the market’s whipsaw (points (a) and (d)). I’m not
saying that crossovers are completely worthless. My point is that they should be
used as a reference only and not as a purely mechanical system in and of itself.

 

Chart 3, Cash S&P Index-Using Moving Average Crossovers as Trading Signals. Large trends such as points (b) and (c) are occasionally captured by using this system. However, for the most part, the system will lose money due to the market’s whipsaw (points (a) and (d)).

Slope of moving average

One of the least complex and possibly most useful ways to use a moving
average is to simply look at its slope. If the slope is rising then the market
is in an uptrend. On the other hand, if the slope is falling then the market is
in a downtrend. This is illustrated in Chart 4, March 2000 Coffee. Keep in mind
that you can’t really base a system purely on this approach but trading with the
trend based on the slope of the moving average may help keep you out of trouble.

 

Chart 4, March 2000 Coffee-Using the Slope of the Moving Average to Gauge Performance. Although you probably can’t base a system solely on the moving average slope, a positive slope suggests an uptrend while a negative slope suggests a downtrend.

Using the Moving Average for Support/Resistance &
Reference Points

Markets will often find support and resistance at the moving averages. For
instance, if a market is in an uptrend and begins to correct, it should not
trade below its immediate term moving average. For example, in stocks, the 50
day moving average usually provides a good point of reference as it is watched
by large traders and institutions. Stocks should stay above the average and find
support there during corrections. This is illustrated in Chart 5, Cisco Systems
(CSCO).
On the other hand, in downtrends they should find resistance at the moving
average during relief rallies.

 

Chart 5, Cisco Systems-Using the Moving Average as a Reference for Support. Notice that the stock finds support at or near the 50-day simple moving average.

Looking Ahead

Now that we’ve defined the different types, characteristics, and uses of
moving averages we’re ready to look at more specific strategies involving moving
averages. In our third and final installment on moving averages, we’ll look at
specific strategies involving moving averages.

*In their defense, moving average crossovers did seem to work before
the widespread use of computers. You should, however, be suspect of any newer
books which discuss the technique as a viable mechanical system.

References and Additional Reading

Technical Analysis From A to Z by Steven Achelis. I keep this book on my desk
for quick reference. Mr. Achelis covers most technical indicators including
their calculation and general use in a clear and concise manner.

For those looking to jump ahead, I will likely reference moving average
strategies in upcoming articles from some of the following books and/or
articles:

The 2/20 EMA Breakout System, by David Landry, December 1996 issue of
Technical Analysis of Stocks and Commodities.

The TradingMarkets.com Guide to Conquering the Markets,
Edited by Mark Etzkorn. The Running Cup and Handle, Chapter 6, pages 74 through
76.

Hit and Run Trading by Jeff Cooper. Expansion
Pivots, Chapter 8, pages 59 through 67.

Street Smarts by Laurence Connors and Linda
Raschke.
The Holy Grail, Chapter 10, pages 79 through 86