In this module of “Technical Analysis demystified” we look at the various types of moving averages and how the signals generated can be used by traders.
About Moving Averages
In technical analysis, a Moving Average is a trend-following device. It never anticipates, only reacts. It is a smoothing device.
Most of stock traders rely heavily on 50 and 200-day Moving Averages in the medium-term. For longer term, they use 30 week and 40 week Moving Averages.
A Simple Moving Average is basically an arithmetic mean. It gives equal weight to each day’s price.
A Linearly Weighted Moving Average is calculated in the following way: the closing price of the 10th day will be multiplied by 10, the 9th day by 9, etc…The total is then divided by the sum of multiples.
An Exponentially Smoothed Moving Average assigns greater weight to the more recent data and this include all the data in the life of the contract. Typically, it assigns a 5 value to the last day’s price.
NB: it would appear that the difference between an exponential moving average and a simple moving average is minimal. But the exponential moving average is consistently closer to the actual price.
The Adaptive Moving Average is based on an Efficient ratio (ER) equals to the Price direction divided by the level of risk.
If ER is high, the average is faster.
If ER is low, the average is slower.
How to use Moving averages
A BUY signal is triggered when the closing price is above the Moving Average. For added confirmation, the Moving Average must turn itself.
Under the double crossover method (or golden cross), the shorter moving average must be above the longer average (i.e it crosses above). This lags a bit more than single Buy signal.
Traders can also use 3 averages (4 > 9 > 18). They will BUY when 4 crosses above 9 AND 18. A confirmation takes place when 9 days moving average is above the 18 days moving average.
When 3 Moving Average of relatively different time span converge, it indicates that:
- The balance between buyers & sellers is evenly matched
- The price is set up ready for a relatively large move in either direction
Also called channels, bands can be created in many ways:
- A fixed percentage above and below the average (e.g 3% around a single 21-day MA)
- An absolute point value
- A volatility function
Moving Average envelopes
A simple moving average line can be enhanced by surrounding the line pattern with parallel envelopes. These envelopes deviate from the moving average line by a user-specified percentage in order to determine when prices have strayed from the moving average line by that percentage. For example, charting 3% envelopes would display an upper parallel line that is 3% above the Moving Average line, and a lower parallel line that is 3% below the Moving Average line.
Moves outside of the 3% envelopes are significant for short term traders who are more concerned with smaller price fluctuations.