Tips of Using Moving Averages

The moving average is one of the most versatile and widely used of all technical indicators. It is the basis for many mechanical trend-following systems in use today. There are many questions to be considered when using moving averages. Here we address some of the more common usages of the moving average.

The moving average is a smoonthing device with a time lag.

The moving average is essentially a trend following device. Its purpose is to identify or signal that a new trend has begun or that an old trend has ended or reversed. Its purpose is to track the progress of the trend. It does not, however, predict market action. It never anticipates; it onlyreacts. The moving average follows a market and tells us that a trend has begun, but only after the fact.

The moving average is a smoothing device. By its very nature, however, the moving average line also lags the market action. A short moving average, such as a 20 day average, would hug the price action more closely than a 200 day average. The time lag is reduced with the shorter averages,but can never be completely eliminated. Shorter term averages are more sensitive to the price action, wheareas longer range averages are less sensitive.

The Use of One Moving average

Some traders use just one moving average to generate trend signals. The simple moving average is the one most commonly used by technicians. The moving avearage is plotted on the bar chart in its appropriate trading day along with that day’s price action. When the closing pirce moves above the moving average, a buy signal is generated. A sell signal is given when prices move below the moving avearge.

A shorter average gives earlier signals. While the longer average is slower, but more reliable.

For added confirmation, some technicians also like to see the moving average line itself turn in the direction of the price crossing. If a very short term average is employed, the average tracks prices very closely and several crossing occur. The use of a very sensitive average produces more trades and results in many false signals, but it has the advantage of giving trend signals earlier in the move. The more sensitive the average, the earlier the signals will be. The longer averages work better as long as the trend remains in force, but a shorter average is better when the trend is in the process of reversing.

Use Two Averages to Generate Signals

It becomes clearer that the use of one moving average alone has several disadvantages. It is usually more advantageous to employ two moving averages. This technique is called the double crossover method. This means that a buy signal is produced when the shorter average crosses above the longer. This technique of using two averages together lags the market a bit more than the use of a single average but produces fewer whipsaws.

Moving Average Envelopes

The usefulness of a single moving average can be enhanced by surrounding it with envelopes. Percentage envelopes can be used to help determine when a market has gotten overextended in either direction. The envelopes are placed at fixed percentages above and below the average. Shorter term traders often use 3% envelopes around a simple 21 day moving average. When prices reach one of the envelopes, the short term trend is considered to be overextended. For long range analysis, some possible combiantions includes 5% envelopes around a 10 week average or a 10% envelope around a 40 week average.