Episode #8 - Tutorial in Technical Analysis by Alan Hull September 13, 2023

Introduction to moving averages

Prior to the advent of personal computers, charting was very much a manual and fairly tedious pursuit and therefore analysis techniques rarely went beyond the application of a few trendlines. However, thanks to the introduction of PCs and software like Stockopedia, we can now generate price charts in a matter of seconds.

Moreover, we can very quickly and easily make fairly complex calculations based on price information in order to design and create a vast range of what we call technical indicators. And the most basic building block of nearly all modern technical indicators is the moving average.

In previous modules I’ve often remarked that chartists need to exercise discretion…an obvious example being the placement of trendlines. But one way to minimize the use of discretion is by defining price trends using moving averages rather than trendlines. Furthermore, because price activity doesn’t always progress in a straight line, it is often more helpful to use moving averages which will ‘bend’ in sympathy with price activity.

A moving average being used as a trendline

It is important to note that when calculating a moving average it is the convention to use the closing price as, explained in an earlier module, this is considered to be the most significant price component. Hence, all commercially available charting programs will, by default, use the closing price to calculate moving averages.

Simple moving average

A simple moving average (SMA) smoothes out the price activity on a chart by adding together the prices of ‘X’ number of trading periods and then dividing it by ‘X’. As each new trading period occurs, the average is then recalculated and all the averages are then connected using a single unbroken line. So to calculate a simple 5 week moving average the following formula would be applied.

5 Week SMA = Price for week1+week2+week3+week4+week5

The name ‘Simple Moving Average’ is used because it is created using the formula for calculating a ‘Simple Average’. This type of moving average has been in use by chartists since the early 1900s, although you can appreciate how time consuming it was to calculate and draw an SMA by hand.

But as I’ve already mentioned, we have charting software that does it all for us and so creating the following chart took me less than a minute. Also note that in this chart I have made the price candlesticks grey so the 5 week simple moving average line is easy to see…

Weekly price chart with a 5 week simple moving average

The number of days used in calculating a moving average is entirely up to the chartist and once again we see discretion creeping into the process. However it should be noted that the lower the number of periods used, the closer the moving average will track the underlying price activity.

For instance, looking at the following chart where I‘ve applied both a 5 week and a 20 week simple moving average, you can clearly see that the 5 week SMA sits much closer and is often over the top of the price activity. Also note how the 5 week SMA line isn’t as smooth as the 20 week SMA line…

5 week SMA (black line) and 20 week SMA (grey line)

Crossover Signals

A common method of generating buy & sell signals is to compare a fast moving average (with a low number of periods) with a slow moving average (a high number of periods). These two lines will crossover each other when the price activity changes direction. This method was one of the very earliest systematic trading systems ever employed and is still in use by many chartists today.

When the fast moving average crosses up through the slow moving average then a buy signal is generated and when it crosses down through the slow moving average then a sell signal is generated. The choice of the values of the fast & slow moving averages is subjective but common values that chartists will often use for generating crossover signals is 9 and 21. This was in fact the convention when I started charting many years ago and to this day I’m not aware of the reason for it.

Crossover methods work by responding to changes in price where the two moving averages lag the immediate price activity to varying degrees. If a chartist ‘Shortens’ the value of the averages to make them more responsive he or she will encounter whipsawing. Whipsawing is when the two averages run almost parallel to one another and constantly touch or crossover generating false buy and sell signals.

You can see in the above historical chart of Telstra how the 9 day and 21 day periods work well, giving very clean buy and sell signals as Telstra’s share price changes direction. Of course this won’t always be the case and therefore adjusting the periods of the two moving averages to ‘Curve fit’ them to each share is a common practice.

Furthermore, it should also be noted that it’s never a good idea to use any single indicator or technique when charting. The best approach is to employ several techniques that compliment each other.

This is so the weakness of one indicator can be counteracted by the strength of another indicator. We will look more closely at how to combine different charting techniques when we get to the more advanced modules. But in the next module we will extend our discussion on moving averages by taking a look at weighted moving averages.

More to come next time...

---

Alan Hull’s company ActVest Pty Ltd is a Corporate Authorised Representative (CAR No.306718) of Avestra Capital Pty Ltd AFSL 292 464 ("Avestra"). This document has been prepared for the general information of investors and does not take into account the investment objectives, financial situation and particular needs of any particular person.

Past performance is not a reliable indicator of future performance.

Persons intending to act on information in this document should seek professional advice to confirm that the investments or strategies mentioned are appropriate in the light of their particular investment needs, objectives and financial circumstances prior to taking any action.

While reasonable care has been exercised and the statements contained herein are based on information believed to be accurate and reliable, neither ActVest, Avestra, nor their employees or agents shall be obliged to update you if the information or its advice changes or be liable (unless otherwise required by law) for any loss or damage suffered or caused to any person or corporation resulting from or contributed to by any error or omission from such statements including any loss or damage caused by any fault or negligence on the part of ActVest, Avestra or Stockopedia, whether direct, indirect, consequential or otherwise, whether foreseeable or not.

Direct investing in the stock market can result in financial loss. This document, and any associated files, is intended solely for its intended recipient. The contents are confidential and may be legally privileged.