Monday, November 12, 2012

MOVING AVERAGES

Commonly used time intervals for Moving Averages (MA) include 1 minute, 5 minute 10 minute, 15 minute, 30 minute, Hourly, Daily, Weekly and Monthly; all rules apply regardless of the time interval but for discussion purposes the Daily Moving Average (DMA) will be referred to.
 
Shorter period (5,10) DMAs are more sensitive and identify new trends earlier, but also give more false alarms. Longer period (50,100,200) DMAs are more reliable but less responsive, only picking up the larger trends.

The simplest MA system generates signals when price crosses the MA:
Go long when price crosses above the MA.
Go short when price crosses below the MA.

A moving average is commonly used with time period series data to smooth out short-term fluctuations and highlight longer-term trends, changes in trend or cycles.  Nothing more.  They do not predict price direction, but rather define the current direction with a lag. Moving averages lag because they are based on past prices. Despite this lag, moving averages help smooth price action and filter out the noise. They also form the building blocks for many other technical indicators and overlays, such as Bollinger Bands, MACD and the McClellan Oscillator.

SMAs and EMAs
The two most popular types of MAs are the Simple Moving Average (SMA) and the Exponential Moving Average (EMA). These MAs can be used to identify the direction of the trend.

SMA represent a true average of prices for the entire time period. As such, SMAs may be better suited to identify price levels that are in close proximity to the SMA.

EMA applies weighting factors which decrease exponentially. The weighting for each older datum point decreases exponentially, never reaching zero.  EMAs have less lag and are therefore more sensitive to recent prices - and recent price changes. EMAs will turn before SMAs.
 
5 10 20 50 200 or
FIBONACCI SERIES 5 8 13 21 34 55
(commonly used in algorithm based trading systems)

For short term MA may be (5 or 10) DMAs while the slower MA (21,34) is medium or long term MA (50,100 or 200 DMAs). A short term MA (5,10) is faster because it only considers prices over short period of time and is thus more reactive to daily price changes. On the other hand, a long term MA (50,100,200) is deemed slower as it encapsulates prices over a longer period and is more lethargic. However, it tends to smoothen out price noises which are often reflected in short term MAs.

The 200 Day SMA is used to separate bull territory from bear territory. Studies have shown that by focusing on long positions above this line and short positions below this line can give you a slight edge. It is also used as a percentage above or below price for execution. For example, if a stock price trades over 100% above the 200 DMA, the trader is inclined to sell part or all of the stock because it is overbought and due for a pull back.

SUPPORT and RESISTANCE
Contrary to popular belief, stocks do not find support or run into resistance on MAs. Many times you will hear traders say, "it bounced off of the 50 DMA!"

But that is not the case!

A stock will not suddenly bounce off of a line that some chartist put on a stock chart, but it will bounce off of significant price levels that occurred in the past - not a line on a chart.  However, stocks will reverse (up or down) at price levels that are in close proximity to popular MAs but they do not reverse at the line itself. 

A short-term uptrend might find support near the 20 DMA, which is also used in Bollinger Bands. A long-term uptrend might find support near the 200 DMA, which is the most popular long-term MA. If fact, the 200 DMA may offer support or resistance simply because it is so widely used. It is almost like a self-fulfilling prophecy. However, in reality true support or resistance is at price levels that are in close proximity to popular moving averages.

RISING and FALLING SLOPES and STACKING
The rising MA is a technical indicator used in trading. Most commonly found visually, the pattern is spotted with a MA overlay on a stock chart or price series. When the MA has been rising consecutively for a number of days, this is used as a buy signal, to indicate a rising trend forming.

Relative strength is indicated when rising MAs stack above their longer term MAs.  For example, a rising 10 DMA is above a rising 20 DMA, is above a rising 50 DMA is above a rising 200 DMA.

CROSSOVERS
Two MAs can be used together to generate crossover trend change signals in technical analysis.  Double crossovers involve one relatively short MA and one relatively long MA. A system using a 5 Day EMA and 34 Day EMA would be deemed short-term. A system using a 50 Day SMA and 200 Day SMA would be deemed medium-term, perhaps even long-term.

Death and Golden Crosses
·         Death Cross occurs where the 50 DMA falls below the 200 DMA is a bearish technical signal
·         Golden Cross occurs where a short-term DMA breaks above  its long-term DMA is a bullish technical indicator

A crossover can be used to signal a change in trend and can be used to trigger a trade in a Black Box (Algorithm based) trading system.  One of the most common buy trigger is when the 5 Day EMA crosses above the 34 Day EMA.
 

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