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 most simple 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 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 (ie. 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
Hi Stephen,
I have a general question on Moving Average time lengths, this also applies to indicators.
Which time lengths are best for UK centric markets (particularly shares).
I’ve recently read Alex Elder, Marc Minervini and most recently Brian Marber. They all give different suggestions for time lengths.
– Elder EMA of 11 and 22 periods together with MACD (12,26,9) and a 5-day Stochastic
– Minervini – 50, 100 and 200 period EMA + volume indicators
– Marber – 21, 63 252 period SMA + 63 day ROC, 34-day Stochastic, MACD, 9-day RSI and a 5-day Stochastic.
Minervini’s times are very standard, and appear to be US centric. Marber argues strongly that they are unsuitable for UK, and through basic maths has settled on the 21-63-252 format as it fits the UK trading month/year).
I see in this article that you have used the ubiquitous 50 SMA – is that what you use in real trades. I can see Marber’s point of view, but don’t want to disappear down a rabbit hole tweaking times and all manner of things – when it should really be trading.
I am really enjoying your series here and on Stockopedia.
Look forward to hearing from you.
Hi Mark,
Good question. If you’re following the strict letter of the law then the standard 50,100,200 are the sort of numbers most commonly taught. They are the ones I use. Why? Because on balance, the rest of the world mostly use them. To me I like to go where the money is (follow the flow) and most will be basing their decisions on the standard suite of moving averages. I also like to keep things simple. I can see why Marber might tweak the numbers slightly, but I’d also point out that in UK equities some of the biggest investors are non-UK based (Chinese,US, funds, banks, systematic programmes etc etc) and will more than likely use the traditional rounded moving averages. When teaching about moving averages, I always caution around ‘fitting’ the moving average to get the result you want – this can lead to trouble and that is why I stick with the globally common averages. I’d also say that 50,100,200 are not specifically US centric – they are also widely used in the UK. Again when I teach on the UK Society of Technical Analysis diploma course they are the averages most taught. To counter that there is no rule to say you cant use a moving average of your choice. In the world of futures they sometimes use slightly different numbers. I was an LME metals trader – a very UK centric market – in that we used the standard: 10,20, 50,100,200 as common practice.
In regards indicators for example, the MACD has a specific default moving average, so does Ichimoku for that matter, again as a start the defaults I like to stick with but there is nothing to stop you changing these. For example RSI normally defaults to a 14 period but if you want something faster, then you could use 7 or even 5 periods. This is the area I’m most likely to tweak according to the market I’m trading.
Hope that helps?
Regards
Stephen
Thanks Stephen,
Very useful. You can see why people new to TA can get so confused. Everyone has an opinion and most things conflict.
I can see the value of using slightly off beat things as it prevents you doing what everyone else is doing. However, TA is mostly about having a window into crowd behaviour and what most people are ‘thinking and feeling’. If most people are using the common time frames (50,100,200) then that will reflect in their behaviour. Therefore, to understand the behaviour, one should use the same. Sorry that’s rambling, but I think this now makes sense.
Thanks for being patient.
No problem. Exactly how I think about it. Sometimes how I put it into perspective: the Pamplona Bull run in Spain – when they open the gates which way do you run? You run with the bulls – unkless you’re seriously stupid or know something the rest of us dont! Yes you may have a cunning strategy to avoid the bulls that involves maybe running toward them but it’s going to be harder to deploy and has an increased chance of failure! So in relation to your question, running with the bulls ie the money, the flow is like using the 50,100,200 moving averages. Tinkering with the averages is like having the cunning strategy but much harder work! You’re 100% correct – understanding the behaviour and psychology of the market is I think equally as critical to your success.
Regards
Stephen