Moving Averages

Alexander Elder - Trading For A Living

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MOVING AVERAGES
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Wall Street old-timers claim that moving averages were brought to the financial markets by antiaircraft gunners. They used moving averages to site guns

on enemy planes during World War 11 and applied this method to prices. The two early experts on moving averages were Richard Donchian and J. M. Hurst —neither apparently a gunner. Donchian was a Merrill Lynch employee who developed trading methods based on moving average crossovers. Hurst was an engineer who applied moving averages to stocks in his now-classic book, The Profit Magic of Stock Transaction Timing.

A moving average (MA) shows the average value of data in its time window. A 5-day MA shows the average price for the past 5 days, a 20-day MA shows the average price for the past 20 days, and so on. When you connect each day's MA values, you create a moving average line.

The value of MA depends on two factors: values that are being averaged and the width of the MA time window. Suppose you want to calculate a 3-day simple moving average of a stock. If it closes at 19,21, and 20 on three consecutive days, then a 3-day simple MA of closing prices is 20 (19 + 21 + 20, divided by 3). Suppose that on the fourth day the stock closes at 22. It makes its 3-day MA rise to 21 - the average of the last three days (21 + 20 + 22), divided by 3.

There are three main types of moving averages: simple, exponential, and weighted. Most traders use simple MAs because they are easy to calculate, and Donchian and Hurst used them in precomputer days. Simple MAs, however, have a fatal flaw —they change twice in response to each price.

Twice as Much Bark

A simple MA changes twice in response to each piece of data. First, it changes when a new piece of data is added to the moving average. That is good—we want our MA to reflect changes in prices. The bad thing is that MA changes again when an old price is dropped off at the end of the moving average window. When a high price is dropped, a simple MA ticks down. When a low price is dropped, a simple MA rises. Those changes have nothing to do with the current reality of the market.

Imagine that a stock hovers between 80 and 90, and its 10-day simple MA stands at 85 but includes one day when the stock reached 105. When that high number is dropped at the end of the 10-day window, the MA dives, as if

in a downtrend. That meaningless dive has nothing to do with the current reality of the market.

When an old piece of data gets dropped off, a simple moving average jumps. A simple MA is like a guard dog that barks twice — once when someone approaches the house, and once again when someone walks away from it. You do not know when to believe that dog. Traders use simple MAs out of inertia. A modern computerized trader is better off using exponential moving averages.

Market Psychology

Each price is a snapshot of the current mass consensus of value (see Section 12). A single price does not tell you whether the crowd is bullish or bearish—just as a single photo does not tell you whether a person is an optimist or a pessimist. If, on the other hand, someone brings ten photos of a person to a lab and gets a composite picture, it will reveal that person's typical features. If you update a composite photo each day, you can monitor trends in that person's mood.

A moving average is a composite photograph of the market—it combines prices for several days. The market consists of huge crowds, and a moving average identifies the direction of mass movement.

The most important message of a moving average is the direction of its slope. When it rises, it shows that the crowd is becoming more optimistic— bullish. When it falls, it shows that the crowd is becoming more pessimistic—bearish. When the crowd is more bullish than before, prices rise above a moving average. When the crowd is more bearish than before, prices fall below a moving average.

Exponential Moving Averages

An exponential moving average (EMA) is a better trend-following tool than a simple MA. It gives greater weight to the latest data and responds to changes faster than a simple MA. At the same time, an EMA does not jump in response to old data. This guard dog has better ears, and it barks only when someone approaches the house.

EMA = P tod • K + EMA yest • (1 - K)

Technical analysis software allows you to select the EMA length and calculate it at a push of a key. To do it by hand, follow these steps:

• Choose the EMA length (see below). Let us say, we want a 10-day
EMA.

• Calculate the coefficient K for that length (see above). For example, if
you want a 10-day EMA, K equals 2 divided by 10 + 1, or 0.18.

• Calculate a simple MA for the first 10 days—add closing prices and
divide the sum by 10.

• On the 11th day, multiply the closing price by K, multiply the previous
day's MA by (1 - K), and add the two. The result is the 10-day EMA.

• Keep repeating step 4 on each subsequent day to obtain the latest
EMA (see worksheet, Figure 25-1).

An EMA has two major advantages over a simple MA. First, it assigns greater weight to the last trading day. The latest mood of the crowd is more important. In a 10-day EMA, the last closing price is responsible for 18 percent of EMA value, while in a simple MA all days are equal. Second, EMA does not drop old data the way a simple MA does. Old data slowly fades away, like a mood of the past lingering in a composite photo.

Choosing the Length of a Moving Average

A relatively short EMA is more sensitive to price changes —it allows you to catch new trends sooner. It also changes its direction more often and produces more whipsaws. A whipsaw is a rapid reversal of a trading signal. A relatively long EMA leads to fewer whipsaws but misses turning points by a wider margin.

When computers first became available, traders crunched numbers to find the "best" moving averages for different markets. They found which MAs worked in the past —but it did not help them trade because markets kept changing. Our brokers do not let us trade the past.

It pays to tie EMA length to a cycle if you can find it. A moving average should be half the length of the dominant market cycle (see Section 36). If you find a 22-day cycle, use an 11-day moving average. If the cycle is 34 days long, then use a 17-day moving average. Trouble is, cycles keep changing their length and disappearing. Some traders use software such as MESA to look for valid cycles, but MESA shows that noise is greater than cycle amplitude most of the time.

Finally, traders can fall back on a simple rule of thumb: The longer the

trend you are trying to catch, the longer the moving average you need. You need a bigger fishing rod to catch a bigger fish. A 200-day moving average works for long-term stock investors who want to ride major trends. Most traders can use an EMA between 10 and 20 days. A moving average should not be shorter than 8 days to avoid defeating its purpose as a trend-following tool. I have been using a 13-day exponential moving average for most of my trading in the past several years.

Trading Rules

A successful trader does not forecast the future — he monitors the market and manages his trading position (see Section 17). Moving averages help us to trade in the direction of the trend. The single most important message of a moving average is the direction of its slope. It shows the direction of the market's inertia. When an EMA rises, it is best to trade the market from the long side, and when it falls, it pays to trade from the short side (Figure 25-2).

• When an EMA rises, trade that market from the long side. Buy when
prices dip near or slightly below the moving average. Once you are
long, place a protective stop below the latest minor low and move the
stop to the break-even point as soon as prices close above their EMA.

• When the EMA falls, trade that market from the short side. Sell short
when prices rally toward or slightly above the EMA, and place a pro
tective stop above the latest minor high. Lower that stop to the break
even point as soon as prices close below their EMA.

• When the EMA goes flat and only wiggles a little, it identifies an aim
less, trendless market. Do not trade using a trend-following method.

Mechanical Systems

The old mechanical trading methods using moving averages usually had four steps: (1) Buy when the MA rises and prices close above it; (2) sell when prices close below the MA; (3) sell short when the MA declines and prices close below it; (4) cover shorts when prices close above the MA. This mechanical method works in trending markets but leads to whipsaws when markets go flat.

Trying to filter out whipsaws with mechanical rules is self-defeating — filters reduce profits as much as losses. An example of a filter is a rule that requires that prices close on the other side of MA not once, but twice, or that they penetrate MA by a certain margin. Mechanical filters reduce losses, but they also diminish the best feature of a moving average — its ability to lock onto a trend early.

Figure 25-2 Thirteen-Day Exponential Moving Average

When the EMA rises, it shows that the trend is up and the market should be traded from the long side. The best time to buy is when prices return to their EMA-not when they are high above it. Those trades offer a better risk/reward ratio.

When the EMA declines, it shows that the trend is down and the market should be traded from the short side. It is best to sell when prices rally back to their EMA. When the EMA goes flat, as it did in December, it tells you that the market has stopped trending. Stop using a trend-following method but continue to track this indicator, waiting for it to enter a trend.

The favorite approach of Donchian, one of the originators of trading with moving averages, was to use crossovers of 4-, 9-, and 18-day MAs. Trading signals were given when all three MAs turned in the same direction. His

method, like other mechanical trading methods, only worked in strongly trending markets.

A trader must accept that an EMA, like any other trading tool, has good and bad sides. Moving averages help you identify and follow trends, but they lead to whipsaws in trading ranges. We will look for an answer to this dilemma in Chapter 9 on the Triple Screen trading system.