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Moving average

This is probably the most widely used and most popular indicator of all. It can assist in determining the direction of a trend and it can be used as an overbought / oversold indicator. When used in conjunction with other indicators, including other moving averages, it can generate buy and sell signals, thus providing a complete trading system if used intelligently.

Ultimately it has a smoothing affect and it can be used to remove noise from the market, by reducing a basic open/high/low/close bar chart even further to a simple line chart. 

Moving Average(n) = [Price(n) + Price(n-1) + Price(n-2) + ... + Price(n-m)] / m

where

  • n is the current period
  • Price is the closing price
  • m is a parameter selected by the user
  • m is the number of samples used to construct the indicator
  • when calculating the next value, drop the oldest value and add the most recent

The selection of 'm' is all important when using this indicator. It can vary from the smallest, a 3 period indicator, to a commonly used, 200 day moving average, which is considered a long term indicator.

There are several ways to construct the indicator, depending on which price is used. 
The Simple Moving Average
The above example uses a closing price and is therefore referred to as a simple moving average. 
The Centered Moving Average
The centered moving average uses the centre of the bar instead of the closing price. 
The Weighted Moving Average
This indicator attributes more weight to more recent data, thus reflecting a belief that more recent data is more relevant to the next data point.

How to use Moving Averages

A moving average is a great way to identify the trend and it can be tuned to your own particular time frame. A lot of traders use it as their final filter and will only act if the moving average is trending in the direction of the signal or if price is on the same side of the moving average as the signal is indicating.

A moving average can be plotted with an envelope using a user nominated percentage deviation above and below the moving average line. While the price action lies within the envelope one can say that the market is in a neutral state, however when it probes above the envelope it would reflect an overbought state and below, an oversold state. This can be employed gainfully during sideways market activity.

Moving Average Cross

The obvious extension of the simple moving average is to use 2 or 3 moving averages of varying lengths, time periods, such as 8, 21 and 55. The first two reflect the state of the short term and the last two the state of the longer term trend. Signals are generated when two of the moving averages cross and the direction of the signal is the same direction as the direction that the short term crosses the longer term. 

If the short term indicator is above the long term the market has an underlying bullish trend. Conversely if the short term indicator is below the long term moving average then the market is in a bear market, reflecting a bear trend.

It is important to realise that moving average indicators work best in trending markets. If the market is sideways and directionless, then there is a greater chance of being 'whipsawed'. Nevertheless this can be eliminated if a long term moving average is used to determine whether the market is indeed trending or not, in the relevant time frame. Failing that, it is possible to employ another indicator such as the MACD to determine whether the market is trending or not. Remember, of course, that the MACD Moving Average Convergence Divergence indicator is actually a derivative of the Simple Moving Average. If we recognise the market as being in a non-trend state then we can use the indicator as an overbought/oversold indicator.

In the example above, the blue line is the fastest and uses an 8 period moving average. A 21 period moving average was used to make the red line and finally a 55 period, in this case day, moving average was used to plot the green line. The green line is the best indicator to the longer term trend, which has turned from up to neutral. The shorter duration lines generated a sell signal back above 32500, when the blue line crossed below the red line. The signal was more or less confirmed when the short term line, the blue line, crossed below the green, long term line. 

It should be pointed out that the best exit signal for a moving average cross trade is not necessarily a cross in the other direction. It is wise to consider other indicators and a strict set of trading rules to enhance the signals generated by the Simple Moving Average indicator, in all its forms.

Disclaimer
© The MacLean Group Pty Ltd ACN 096 967 038. All rights reserved 2003. This article has been prepared by The MacLean Group and licensed to ASX. The views are those of the author and not of ASX. This material is educational and it is not intended to constitute financial advice.

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