Moving averages: use and methods

When using technical analysis, I prefer the most simple, objective methods. The reason for this is that these methods are the used the most and are objective, which give the best results. In an earlier article, I discussed the different types of technical analysis and I promised to describe different indicator driven technical analysis methods. In this article I will discuss the use and different variations on the moving average method. One of the goals that the moving average can be used for, is identifying trends.

Simple moving average

An often used moving average method is the 200-day simple moving average. With this moving average, a trend of a share can be found. By taking the prices of the last 200 days and calculate the mean price of this set of prices, the moving average can be determined. Each new day, the oldest datapoint is deleted from the set, and the latest price is added to the calculation. All the datapoints together will give a line which may show a trend. You can also measure the prices on other moments (not day end), like each hour. This will give you the possibility to find a short term trend.

The moving average does not necessarily have to be measured out of 200 datapoints. Less datapoints is possible, but this gives you an outcome of the trend that is less certain. An advantage of less datapoints is that you will find a possible trend earlier, which gives you the possibility give your orders at an earlier stage.

Long and short term moving averages can both be used, but you will need to know the advantages and the disadvantages. When you use a long term moving average (lots of datapoints), the quality of the indicator will be higher. At the other side, longer term moving averages will lower your spped of reaction, because the trend will be recognized at a later stage. You can mitigate the disadvantages by using a shorter term moving average when the market is volatile and by using the longer term moving average when the markets are stable. This will give you the possibility to respond to the actualities on the market.

Variations on the simple moving average

The simple moving average gives each datapoint the same value, so the moving average is the sum of all values divided by the total number of values.

During the years, some variations on the moving average have been created. The first variation is the time dependent moving average. This moving average is calculated by giving the later prices higher factors. The first price (earliest price) will be multiplied by one, the second by two, the third by three etc. The total outcome will be divided by the sum of all factors. With the time dependent moving average, the current trend will become visible in an earlier stage. The advantage of this is that this gives the possibility to react fast, but the main disadvantage is that the possibility of a false trend is also higher.

The second variation is the volume dependent moving average. This variation on the simple moving average is calculated by multiplying the prices with the volumes of that day. The outcome of that calculation will be divided by the total volume of all days. Prices (or days) on which a high volume was traded will have an higher impact on the volume dependent moving average and thus on the recognition of the trend. With the volume dependent moving average the recognized trend will be more clear. The disadvantage is that high volume days in the distant past will have a high impact on the outcome of this moving average variation.

Use of multiple moving averages

Besides using only one moving average, you can also use different types of moving averages together at the same time. Different types of moving averages means moving averages with different time frames. The most used multiple moving average is the moving average with a 9-day and 26-day moving average for the short term and the 50-days and 200-days moving averages for the longer term. The goal of this indicator (multiple moving averages) is to recognize the turning of a trend. When the moving average with the shortest time frame crosses the moving average with the longest time frame, a change in the trend is a fact. When the shortest moving average crosses the longest moving average upwards, then a buy-signal is given. When the lines crosses the other way around, a sell-signal is given.

Besides the 2-moving average method, some technical analysts also use a 3-moving average indicator. The idea of this indicator is that different levels of a trend can be traced. The extra signal that a 3-moving average indicator may give you is the neutral one. When the shortest moving average is located between the longest and the middle term moving averages, a no buy, no sell (so: hold) signal is given. The buy signal is given when the shortest term moving average is above the middle term and the middle term is located above the longest term moving average. The sell signal is given when the moving averages are in reversed order.

I would like to keep to my adage: the more simple the indicator, the better it is usable. So the 2-moving average method will be more usable than the 3-moving average.

Moving average and trend clarity

When using moving averages, it is important that you can determine the trend in the best way and to lower the risk of false trend. First, the trend clarity will be higher when you consider a waiting time. This period will give you the possibility to confirm the trend with some extra data points. The possibility of a fast response is thus lost, but the trend can be better determined.

A second possibility is to use an extra indicator. For example, you can use the resistance and supportlines for confirmation of the trend. An outbreak above the resistance or below the support, confirms the trend. When the price line bounces back from these lines, the trend is broken and it can even mean that the trend will be turned around. This method can surely be used when using short term moving averages.

A third possibility is the degree of crossing of the lines when useing multiple moving averages or the price line and the moving average line. When the longer term moving average crosses the shorter term moving average with a certain percentage (say 5%), a breach of the trend is more realistic than when the crossing happens with a lower percentage. So, how steeper the cross, the clearer the trend breach.