Understanding Moving Averages (Part 3)

04/02/2008 12:00 am EST

Focus:

Remember, it is one thing to look at a completed moving average line and determine at what point would have been an excellent entry into the market, it is another thing to spot the angle of the line as it is developing and at that point wisely enter the market. A true technical analyst is after what the moving average can tell him or her about the coming hours or days of the market, not what the moving average can prove about what should have been done in the past. That said, look for angles!

Simple Moving Averages

Calculating simple moving averages is really quite simple (no pun intended). As was outlined in the beginning of this section the sum of all closing prices is divided by the number of days in the equation. With each new day the now oldest day that is no longer a part of the time frame is subsequently dropped from the equation. A simple moving average is considered a lagging indicator. In fact, the simple moving average perhaps epitomizes the meaning of lagging indicator in that its visual data often comes a bit after the fact, and can be hard to act on. Nevertheless, simple moving averages are key to understanding the markets general feel of where the price range should be trading at, or the safe zone that we referred to earlier. When prices begin to break away from the moving average line in conjunction with a sharply angled moving average line, basic mathematics is predicting a move up or down in the market. The notable down side is that when observing lagging indicators, this prediction often comes too late; thus the reasons for other types of moving averages, averages that more heavily weigh recent data and can offer quicker predictions.

Exponential Moving Averages

Exponential and weighted moving averages attempt to resolve the issue of lagging directional forecasts. In other words, they often cut to the chase faster, allowing traders to better time the market. Placing greater emphasis on more recent price data does this. Instead of evenly distributing plotted points of a moving average across all candles in the period, a weighted or exponential moving average puts more emphasis on the most recent data; allowing the angle of the moving average to react more quickly.

Theorizing that most recent price data is more important to the immediate future of the market than is older price data is often true, but can certainly be a trader's demise if he or she is not careful. Trading a heavily weighted ten day EMA (exponential moving average) and jumping the gun on an initial angle up on the EMA when just ten to twelve days prior a very strong and long down trend occurred might be a bit naive. Why? It is simple, your ten day EMA is over looking data that is an accurate reflection of recent market sentiment, or price direction. Remember that reading moving averages is about comparing an average view of the market's recent trends to an actual view of recent price data. In other words, is the market trading within its safe zone, or where its average has been lately? If not, it may be an indication of a new direction or trend, but before you pull the trigger cross check your SMA (simple moving average) and gage an evenly weighted average of the market's recent history. Notice in figure 4 that the exponential average reacts more quickly to price chance than does this simple moving average; which can be good or bad, but traders should form the habit of cross checking the two.

Whether using exponential moving averages, weighted moving averages or simple moving averages the objective does not change. You are looking for an average in which the market has been trading. When new candles push significantly through this average in conjunction with a sharply angled moving average line it is time to consider an entry point. History has proved itself; when prices begin trading above the moving average line the market is becoming bullish and traders should be looking for buy entry points. When prices begin trading below the moving average line the market is becoming bearish and traders should look for an opportunity to sell.

More in part 4 tomorrow.

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