Technical Analysis (Part 10): Moving Averages

In Part 9, we dug into the world of price patterns. This week, in Part 10 of our blog series, we explore a common method used in the world of maths and finance to find trends in data; that of moving averages. The moving average is a highly effective, multi-purpose tool that can enhance your technical analytical abilities.

What is a moving average?

The official definition from the technical analytical world gives it as :

‘A moving average is a constant period average (usually prices) that is calculated for each successive chart period interval. When plotted, the moving average shows a smooth line representing the successive, average prices.’

Quite simply, it is a tool for 'smoothing' out the noise from a set of price data over a given period of time. In its raw form, the moving average overlays the price chart.

An example using the FTSE 100 (Chart: Stockopedia) with a 50-period moving average - note how the current uptrend is easily defined by looking at the moving average:

Applying the moving average to your technical analysis

In my opinion, the moving average is a great tool for:

• Trend determination.

• Finding support and resistance levels.

Some basics:

• The moving average can be applied to any time period on your charts e.g 1min, 30min, 4hr, 1day etc.

• Length of time interval: describes the number of (n) inputs (prices) used to calculate the average.

• Can be based on high, low, open but more commonly, close.

• Period selected reflects investors' time horizons.

What periods are best to use? This depends on how quickly you want trade signals.

Types of moving average

There are many types of moving average; essentially, they are all a lagging indicator due to the nature of their calculation. This means that the moving average will always miss the early part of a trend and only become useful as a trend determining tool, when prices are moving in a consistent direction.

The moving average used on the FTSE100 chart above, is a moving average known as the 'simple' moving average. This is probably the most commonly used, as it is the simplest to calculate. It is constructed by adding a set of data and then dividing by the number of observations in the period being examined. If the average is moving upward, then this is designated as an upward trend and if the average is falling, this is determined as a downward trend.

Increasing the length of the moving average will decrease its sensitivity to the change in price. For example, a 200-day moving average will move a lot less than, say, a 10-day moving average. More significance is put on the longer average if it is broken by the price. It will also mean more delayed trading signals. On the flip side, a short-term average will give you many signals but also many more false signals.

Here is the same FTSE 100 chart (Chart: Stockopedia) with a 50-day moving average and a 10-day moving average. Note how the 10 period (blue) moving average intersects the price more frequently than the 50-period moving average:

Popular lengths for moving averages

Round numbers are used as common practice in technical analysis, when applying moving averages: 10, 20, 50, 100, 200.  Why? Before the dawn of the computer age, charts were calculated manually and this was far easier to do using round numbers. These round numbers have remained in today's technology age. Stock traders, for example, rely heavily on the 50-day moving average. A lot of these time periods fit around market cycles.

Apart from the simple moving average, there are two other popular averages in use: 'weighted' and 'exponential'. Both the weighted and exponential moving average give more importance to recent data - the weighted offers a more crude, simplistic approach, whilst the exponential offers a smoother process, decreasing exponential weightings as you move back in time.

What effect does applying each of those types have on the moving average? This time we use the same FTSE 100 chart (Chart: Stockopedia), but stick with the 50-day period and apply it to the simple and exponential averages. Note the increased sensitivity of the exponential average (Red) to the price versus the simple average (Blue):

 Neither are right or wrong to use. Again, it comes down to your personal choice and trading objectives. On top of the 'big three', there are other averages you could use: Wilder, Geometric, Triangular, Variable etc. However, if you stick to the three we've talked about in detail, then you won't go far wrong.

Using the moving average in your trading and investing

Moving averages have numerous applications. You don't just need to use one moving average. Some traders apply two, three or more to create 'cross over' trading systems or use multiple averages to better determine where support and resistance levels are. If you are a longer term trader / investor in the equities markets, you may have heard of the terms 'golden cross' and 'death cross' - these are simply the crossing over of two moving averages (50 day and 200 day) to the up and down side, which give the user a signal as to whether the market under study is either bullish or bearish. (Golden Cross is bullish, Death Cross is bearish)

On the example below,  using the S&P500 (Charts: TradingView) the 50 (Red)  and 200 (Blue) period moving averages have been applied to the daily chart - currently things looking bullish!: 

Moving averages - used to determine if a market is bullish or bearish

Moving average based price tools

Moving averages have other purposes as well. We have seen them applied in their basic form, but they can also be used to construct more complex oscillators and indicators. They also don't just have to be price based. They can come from volume or volatility, for example. Some popular indicators are:

• Envelopes and channels: Keltner, Bollinger Bands

• Coppock Indicator (the bereavement indicator)

• Momentum based tools: e.g. MACD, CCI,

• Volume: McLellan Oscillator

Using the FTSE 100 (Chart: Stockopedia) the MACD (Moving Average Convergence Divergence) is applied underneath the price chart - its purpose is to better spot the trend. It can be used as a trading system in itself.

We will be looking at these indicators and oscillators in much more detail in future articles.

Advantages of moving averages:

• Great for trend determination.

• Can determine support and resistance.

• Can be used to determine price extremes because the moving average is a mean. Price has a tendency to mean revert. Therefore, any distance move away from the mean (measured in deviations) can be a significant opportunity to trade against the trend.

• Can be used as actual trade entry and exit signals and for trade management.

Disadvantages of moving averages:

• Near useless in ‘non-trending’ market environments (i.e. two thirds of the time!)

• Can miss the start / end of trends.

• Can curve fit and over-optimise the moving averages.

Further reading and learning

If you are interested in learning more about moving averages then the following reading may help:

• Technical Analysis of the Financial Markets, John J Murphy, New York Institute of Finance, 1985.

• Technical Analysis, The Complete Resource for Financial Market Technicians, Charles D Kirkpatrick, FT Press, 2006.

Conclusion

Moving averages are another simplifying tool to make technical analysis and your decision making more objective, rather than subjective. A tool that helps support the philosophy of technical analysis based around the concepts of markets trending. Some traders and investors use only the moving average and the derivative oscillators produced from moving averages, as the basis for their trading strategies. The problem with moving averages comes, when markets are not trending and the moving average becomes useless as a tool. Another weakness, is that it misses chunks of price action at the start and end of a trend in markets, due to its calculation process.  Luckily for us though, technical analysis tools have been created to spot such situations!

Next time: Technical Analysis (Part 11): Direct Price Analysis (DPA) - Bands