MOVING AVERAGES

It is evident that trends in prices for any freely

traded entity can be very volatile, almost haphazard
at times. One technique for dealing with this
phenomenon is the moving average (MA). An MA
attempts to tone down the fluctuations of stock prices
into a smoothed trend so that distortions are reduced
to a minimum.
 The three principal types of MAs used in technical
analysis are simple, weighted, and exponential. When the
terms “moving average or MAs” are used in this book, we are
referring to the simple type. Exponential MAs (EMAs) and
weighted MAs (WMAs) will always be specifically referenced.
MAJOR TECHNICAL PRINCIPLE

Moving averages should be thought of as a dynamic

level of support and resistance.
 SIMPLE MA

A simple MA (SMA) is, by far, the most widely used. It is

constructed by totaling a set of data and dividing the sum by
the number of observations. The resulting number is known
as the average or mean average.
In order to get the average to “move,” a new item of
data is added and the first subtracted. The new total is then
divided by the number of observations, and the process is
repeated.
For example, the calculation of a 10-week MA would
follow the method shown in Table 11.1.
 Major Technical Principle
Changes in the price trend are identified by the price
crossing the MA, not by a reversal in the direction of the MA.
 MOVING AVERAGE CHARACTERISTICS

1. An MA is a smoothed version of a trend, and the average

itself is an area of dynamic support and resistance. In a
rising market, price reactions are often reversed as they
find support in the area of the MA. If the rest of the
evidence agrees, it’s not a bad idea to wait for the price to
reach its MA prior to making a purchase.
2. A carefully chosen MA should reflect the underlying
trend; its violation, therefore, warns that a change in
trend may already have taken place. If the MA is flat or
has already changed direction, its violation is fairly
conclusive proof that the previous trend has reversed.
3. If the violation occurs while the MA is still
proceeding in the direction of the prevailing trend,
this development should be treated as a preliminary
warning that a trend reversal has taken place.
Confirmation should await a flattening or a change in
direction in the MA itself, or should be sought from
alternative technical sources.
4. Generally speaking, the longer the time span covered
by an MA, the greater is the significance of a crossover
signal. For instance, the vi olation of an 18-month MA is
substantially more important than a crossover of a 30-
day MA.
5. Reversals in the direction of an MA are usually
more reliable than a crossover. In instances in which
a change in direction occurs close to a market turning
point, a very powerful and reliable signal is given.
However, in most instances, an average reverses well
after a new trend has begun and so is only useful as a
confirmation.
WHAT IS A VALID CROSSOVER?
A crossover is any penetration of an MA.
However, close observation of any chart featuring
an MA will usually reveal a number of whipsaw, or
false, signals.
However, it is possible to avoid some of these
close calls by using filtering techniques. The type of
filter to be used depends on the time span in
question, and is very much a matter of individual
experimentation. For example, we may decide to
take action on MA crossovers for which a 3 percent
penetration takes place.
 MAJOR TECHNICAL PRINCIPLE

If an MA crossover takes place at the same time a

trendline is violated or a price pattern is
completed, these signals strongly reinforce each
other and, therefore, need less in the form of a
filter requirement.
 MAs are usually constructed from closing data.
These are more reliable than intrasession prices
because they reflect positions that investors are
willing to carry overnight or, in the case of weekly
charts, over the weekend.
 During a trading range, MA crossovers have a
strong tendency to be counterproductive. Two
examples are shown in Chart 11.5 for Asian Paints,
an Indian stock. In these situations, it is usually best
to use the outer ends of the trading range for the
signal rather than the MA.
 CHOICE OF TIME SPAN

MAs can be constructed for any time period,

whether a few days, several weeks, many months,
or even years. Optimal selection of length is very
important.
The choice of MA depends on the type of market
trend that is to be identified, i.e., short,
intermediate, or primary. Because different markets
Major Technical Principle Try for consistency, never
for perfection.
Perfection just does not exist in psychologically
driven markets. Generally speaking, long-term time
spans are less influenced by manipulation and
kneejerk random reactions to unexpected news than
are short-term ones. This is why long time spans
usually give the best test results; both daily and
weekly averages work best at or above a 40-period
span.
 The important thing to remember is that an MA is
one tool in the technical arsenal, which is used with
other techniques as part of the art of identifying
trend reversals. Again, it’s important to remember
that we are looking for a time span that works
reasonably well over most securities