Technical indicators can be placed into one of two broad categories:continuation or trend-following indicators, and momentum types of oscillatorsthat try to identify market turns. As you might imagine, the different types ofindicators work best in different types of markets – the trend-followers intrending markets and the oscillators in choppy, sideways markets. You can neverbe sure what the market condition will be, which is one reason why usingmultiple indicators is a good idea to detect when those conditions are changing.
One point that should be emphasized in trying to categorize indicators isthat an indicator's failure may be one of the best trading signals you can get.That is, when a trending indicator breaks, it makes a great reversal indicatorand vice versa – an oscillator signal that fails may suggest a strong trendingmove. So while we are putting an indicator into a category, we don't mean torelegate it to that category forever.
Moving averages are the most popular and widely used technical indicatorbecause they are relative simple to understand and easy to calculate. Inreality, of course, you probably won't be calculating any of these movingaverages (or any other indicator, for that matter) by hand because computers andmost analytical software packages do that for us.
Types of Moving Averages
- Simple Moving Average
- Weighted Moving Average
- Exponential Moving Average
- Multiple Moving Averages
One of the questions that traders often ask is what price to use to constructa moving average. By their nature, moving averages require you to use only oneprice per period so you have to make a choice. For most traders and mostsystems, that probably means the close. However, you can use some combination ofany or all of the open, high, low, close. Or you might choose to use movingaverages of the high or low to determine entry or exit points. Or you mightchoose a mid-point between the period's high and low. In short, as long as youcome up with one price, you can construct a moving average line.
A second frequently asked question is how long should the moving averageperiod be? That depends on how close to the market you want to be and how nimbleyou are as a trader. The shorter the time period, the more likely you will besubject to whipsaw trades. On the other hand, with a longer period, you may missgood entry or exit signals. The only way you will know what works for you is totest various lengths and various types of signals. We'll look at various typesof moving averages and what they offer.
Simple Moving Averages
The red line on the chart below is a 5-day simple moving average. Thecalculation for a simple moving average is pretty simple – you just add up thenumber of prices for the length of the moving average you desire and divide bythe number of periods. As you get a new price, the oldest price in the movingaverage drops off and the new price is added to the total, then you divide bythe number of periods and so on, moving through time. Each price carries thesame amount of weight.
For example, if you had prices of 1, 2, 3, 4 and 5, the total would be 15.Divided by five, the number of prices, the moving average would be three. As youcan see by the chart above, a 5-day moving average runs pretty close to theprices, and any attempts to trade price moves above or below the moving averagewould be pretty tricky, especially during certain periods.
The blue line on the chart below is a 10-day simple moving average. As youcan see, there is a little more room between the price bars and the movingaverage, and this chart provides some longer-term trading opportunities. Thecalculation for this simple moving average is the same as for the 5-day movingaverage except that you now have 10 equally-weighted prices to average.
Many of today's analytical software programs can produce moving averages ofany length. In stocks, for example, you may hear talk of 20-day, 50-day or200-day moving averages, but in futures you are usually dealing with shorterlengths.
Below is another view of a 10-day simple moving average on a wheat futureschart. A basic trading strategy involves going long when the close crosses abovethe moving average and going short when the close crosses below the movingaverage. As you can see, there are times when this simple strategy would workvery well and times when it would put you into whipsaw situations unless youmodify the strategy with some other entry or exit technique.
Weighted Moving Averages
Now let's take a look at what some other types of moving averages look likeso you can compare them with the simple moving average.
The first is the weighted moving average, which is based on the premise thatwhat happens on the most recent days is more important to the future than whathappened during the early part of the moving average period.
For a 10-day simple moving average of prices 1, 2, 3, 4, 5, 6, 7, 8, 9, 10,with 10 the most current price, 9 the price yesterday and so on, you would addthe prices and get a total of 55 divided by 10 or 5.5 as the simple movingaverage. For the weighted moving average, you would multiply 10 times 10, 9times 9, 8 times 8 and so on, putting the most weight on the latest prices. Tosave you the trouble of doing this, the total is 385 divided by the number ofmultipliers or 55 for a weighted moving average of 7.0.
As a new price is added, the oldest price during the length of the movingaverage is dropped as time moves along. So you lose the influence of pricesprior to the start of the moving average period. The green line belowillustrates a 10-day weighted moving average.
Exponential Moving Averages
The 10-day exponential moving average is another weighted moving average,putting more weight on the most recent prices, but includes all the data for thelife of the contract in its calculation. As with the other moving averages, youcan adjust the length of time for the exponential moving average. However, youcan also adjust the constant for the most recent day's price to give it more orless weight in the overall average. Increase the weight to increase itssensitivity or decrease the weight of the last day's price to make it lesssensitive. This is a favorite moving average for many analysts but, again, youdon't have to worry too much about calculating all those complex numbers. Mostcharting software will do it for you in an instant. The red line belowillustrates a 10-day exponential moving average.
Putting Them All Together
So how do the various moving averages compare with one another? The chartbelow includes four types of 10-day moving averages – simple, weighted,exponential and another one that eSignal includes in its package, avolume-weighted moving average. When you put them all together on the samechart, it looks a little like spaghetti and is not very conclusive as to whichone works the best. In general, the exponential and weighted moving averagestend to turn a little more quickly than the simple moving average at the trendreversal points. I usually use the exponential moving average.
Moving Averages – The Floating Trendline
An observation you may have after looking at a chart is why you might want touse a moving average instead of just looking at the chart patterns, where theuptrends, downtrends and so on seem pretty obvious without needing a movingaverage to see what the trend is. One of the main reasons for using a movingaverage, or any technical indicator, is that it provides a precise number for atrading system. A trendline or any other observation on a chart is subjectiveand cannot be used as an input for a trading system. With a moving average, youeither have a crossover signal or you do not – no waffling about it.
Aside from its value in developing precise numbers for a trading system, themoving average can also provide evidence of a trend before you can draw atrendline. For example, on the gold chart below, the major trendline on thechart could not have been drawn until the October lows were in place. In themeantime, the 10-day simple moving average shown below could have acted as sortof a floating or flexible trendline.
One way to use a trendline like this is that when prices reach a peak andthen settle back, you buy in the area of the trendline with a fairly close stop,assuming prices will bounce back up from the trendline, as they did severaltimes on this chart. Or combine this tactic with chart pattern breakouttechniques on the rebound from the trendline. If prices do continue to slip, youare stopped out with relatively small losses. It won't work every time, as thetumble in November indicates, but it can be a good positioning technique.
Using Combinations of Moving Averages
One way to alleviate the problem of whipsaws with short-term moving averagesis to use some combination of moving averages. On the gold chart below, the redline is a 5-day simple moving average and the green line is a 15-day simplemoving average. You can see that prices move back and forth across the red linequite often and in October prices dropped below the green line and wouldprobably have stopped you out of the uptrend, depending on the strategy you areusing.
Instead of using just price and one moving average, you would use crossoversof the moving averages as your entry and exit signals. When the shorter movingaverage crosses above the longer moving average, you buy; when the shortermoving average crosses below the longer moving average, you sell.
On this chart that strategy would have kept you in a long position throughthe setbacks in the uptrend during October. You may still have some difficulttrading periods with this strategy, as the November-December action illustrates,but this smoothing effect should result in fewer whipsaw problems.
If two moving averages are good, maybe three are better. Some traders use acombination of three moving averages and require them to line up in a certainorder before taking a position. In the chart below, we are showing 5, 10 and15-day moving averages but there are several other popular combinations such as5, 10, 20 or 4, 9 and 18.
Whatever the time frame you choose, the strategy is similar. In an uptrendthe shortest moving average, the 5-day red line here, should be on top, themedium-length moving average, the 10-day blue line here, should be in the middleand the longest moving average, the 15-day green line on this chart should be onthe bottom before you establish a long position. For a downtrend and a shortposition, just reverse that order.
Again, this strategy is not whipsaw-proof, and you may miss some tradesbecause it takes a longer time to get the moving averages into a properalignment, but you are trying to capitalize on the longer-term trends whileavoiding those situations that are not as promising and may lead to losses.
Keep in mind that while moving averages are a great price-smoothing technicalanalysis tool, their big disadvantage is that they lag the market.
MACD
Now let's turn to another technical indicator that involves moving averages,Moving Average Convergence-Divergence, or perhaps better known as just MACD.MACD is a trend-following momentum indicator that shows the relationship betweentwo moving averages.
The chart below illustrates a standard 12-26-9 MACD; that is, the differencebetween a 12-day and 26-day exponential moving average. Then a 9-day exponentialmoving average of this difference is plotted on top of the moving averagedifference to act as a signal or trigger line. The traditional strategy withMACD is that, when MACD falls below the signal line, sell; when MACD rises abovethe signal line, buy. Note the MACD crossovers indicated by the vertical lineson the wheat futures chart below and the corresponding price action.
MACD can be plotted as just the two lines or as a histogram that gives a morevisual picture of the difference between the two moving averages. In somestrategies, traders remain long when the histogram bar is above zero or shortwhen the histogram bar is below zero. Another option for more aggressive tradersis to trade changes in the histogram bar length. For example, you stay long aslong as the histogram bars are getting higher above zero, but when the barsbegin to shorten, you have an alert that the trend may change.
MACD can also be used as overbought/oversold indicator when the two movingaverage lines widen, or you can use it to spot weakening trends when itsdirection diverges from the direction of prices.
One of the best uses of MACD can be as a confirming indicator in conjunctionwith some other indicator.
All of this may sound a little complex and difficult to follow, but rememberwe are letting the computer do the work in calculating all the necessarynumbers. You are mainly interested in the results of these calculations that youcan see clearly on the charts.
Summary
Keep in mind that moving averages can be used in a variety of ways and theyare very versatile tools. These indicators provide the precise numbers fortrading systems that the subjective reading of charts cannot.
The main deficiency of most technical indicators, including moving averages,is that they have to depend on prices that have happened in the past. As aresult, they lag what is happening in the market currently. In some cases, thatlag may make a substantial difference in how, or if, they can be usedeffectively.
These indicators won't guarantee trading success, but if they can give you anearly clue about trends and turns ahead of the market crowd, they may help youtrade more profitably.
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