Since my Titles are getting a little long, I'll start abbreviating Technical Analysis as 'TA' in my articles I've been formulating for my ongoing Trader's Corner
foundational series. Before launching into my moving average topic I'll make brief comments relating to queries I got over the last 24 hours.
As to how I ascertained that a short-term rally/rebound might be seen by Tuesday of this week, it was an educated guess based on the hourly chart and how oversold the major indexes had gotten by Friday (8/13) on the 21-hour Relative Strength Index or RSI. The RSI and its usefulness as a trading input was my topic last week in this space. Moreover, the S&P 500 (SPX) had by this past Friday gotten close to retracing half of the last upswing. A common retracement is around half of the prior move before a countertrend rally sets up and that's what happened.
A secondary factor in my thinking was that Tuesday and Thursday are quite often 'reversal days'. Since the trend has been down, I figured that at least an oversold rebound should occur by Tuesday. I'm not anticipating a rally at this juncture that carries back up to or through the prior highs as I envision more of a sideways to lower trend.
Moreover, in the case of the Dow 30 (INDU) at least, which has lately been showing good relative strength compared to the market as a whole, INDU was finding support at its 50-day Simple Moving Average or SMA. A rally in the Dow ought to lead a bounce in stocks in general. Unlike the 50-day, the 200-day moving average, seemed to be 'acting' as resistance yesterday and today as you can see on my second chart. Moving averages are the subject of this Trader's Corner and my next.
MOVING AVERAGE TYPES, USE AND TIME PERIODS (LENGTH): '
As a reference piece I'll first explain how the various moving averages are constructed and then use some chart examples from my (Essential Technical Analysis) book that get into how one average versus another might give you a trading edge.
The Simple Moving Average (SMA) is the most common type of moving average and one that I use most of the time and is also the type that most traders use. A 'simple', or as it can also be called, an arithmetic, moving average is calculated by adding the Closing price of a stock or stock index (or any other instrument) for X number of (trading) periods and dividing the result by the same number of time periods. I should mention that there are uses made for a moving average of both Highs and Lows. Of course short-term averages (e.g., 5, 8 periods) respond quickly to changes in the price of the underlying instrument, while longer-term averages (e.g., 21, 50 etc.) are slow to react. The number of trading periods used is determined by the 'length' setting.
Generally, when you see or hear the term 'moving average', it is in reference to a simple moving average or SMA. This distinction can be important if the comparison is to another type of moving average, an exponential moving average (EMA).
Sometimes the SMA calculation could be the ONLY online option for a moving average study or indicator on online charting sites that have a moving average study as part of their indicator tools. A fairly sophisticated online charting site like Big Charts will allow placement of up to 3 different Simple Moving Average (SMA) indicators, as well as up to 3 different Exponential Moving Average (EMA) studies. I'll get to the EMA shortly.
With PC resident technical analysis software packages like TradeStation, etc., there are options provided to give more weight to the most recent price activity. A weighted moving average assigns a greater percentage value to the closes for X number of recent bars, whether that bar represents an intraday period (e.g., hourly), a day, a week or a month, thereby giving a REDUCED weighting to older prices. The practical effect of this is to make the weighted moving average line follow current prices more closely, with less of a lag than a regular simple moving average.)
Such front-loading is the most popular method of calculating a weighted moving average but is not the only possibility. A variation called linear step-weighting, assigns a fixed increment weighting to each day that is dependent on the duration of the average. For example, in such a 5-day weighted average the most recent dayâ€™s close is 5 times the weight of the first day of the 5-day period; the prior day is 4 times the weight of the first day; the third day is 3 times the weight of the first day of the period and so on.
The exponentially 'smoothed' average (an Exponential Moving Average or 'EMA') is a type of weighted moving average that is probably the second most popular moving average variation. The EMA is probably best known through its use in the Moving Average Convergence Divergence (MACD) indicator. This method allows recent price activity to generate a more rapid change in an average price. A type of smoothing is used which assigns a percent value (for example, .15) to the last period's 'bar' and this value will be added to a percentage of the previous Close. The percentage of the previous dayâ€™s close, in the case of a daily chart, will be the inverse of the weighted percentage; e.g., 15 subtracted from 100, which equals 85% (100 â€“ 15).
Because of this method of EMA calculation, all daily moving average values are modified once the first exponential weighting occurs. The higher the percentage weighting given to the most recent close, the more sensitive will be the resulting moving average to the most recent price change. All data previously used is always part of the new result, although with diminished significance over time.
Because of the inclusion of old data in an exponentially smoothed moving average, a 50% 'smoothing' appears slower than a 2-day simple moving average and a 10% smoothing calculation will cause the resulting average to be slower than a 10-day simple moving average. As a trend continues further in its direction, the exponentially smoothed moving average will lag the trend more than a weighted moving average due to this inclusion of all prior closes, which is the 'smoothing' factor. The longer moving average of the simple, equal-weighted moving average type will lag even more, as the most recent price changes will be averaged with many prior closes.
In the stock chart below, a 50-day simple, weighted and exponentially smoothed average are all applied. For the period of time shown, the lag is greatest with the simple moving average and least with the weighted moving average. Both weighted moving averages, weighted and exponential, in the chart react more quickly to a change in the trend than the simple average.
You can also see in above chart of Wal-Mart that the Weighted moving average acts best as a kind of 'curved trendline' on the advance and that the lows seen on the right (late-'99/early-2000) tended to rebound from the weighted average most often.
For shorter time durations, as in my next chart, which uses a 10-day period or moving average length, there is little apparent difference between the three moving average variations, as all moving average types trace out a double or 'W' bottom along with prices:
Taking a close up view of a 30-day period when there was a minor
trend change as shown in our next chart, it becomes apparent that
the first moving average to turn up was the EMA:
The Exponential Moving Average along with the Weighted moving average can be made more, or less, sensitive to the most recent price changes by what 'weighting' factors are used. For sure, both types will turn up or down significantly quicker than a simple moving average unless all are of a very short duration, like a 3-day average.
At 10-days or longer, the gain in a crossover 'signal' can be a few days, so use of front weighted averages will appeal to traders who can deal with the periods of getting 'false' or pre-mature turns in the weighted moving averages as they are more sensitive to recent large price moves.
I usually assume that the weighted moving averages are most appropriate for shorter-term trading, where the average transaction is completed in 1-day to 1-week. Simple moving averages, especially in the 50-200 length range, are appropriate for an investment oriented time frame of longer duration, which is many weeks to months, or even years, as long as a major trend continues.
The importance of the exponentially smoothed average will principally be of interest to most users of basic technical indicators because the popular Moving Average Convergence Divergence indicator or MACD ('macdee'), uses the exponentially smoothed method of calculating a price average.
MOVING AVERAGE TIME PERIODS (LENGTH)
There have been many questions I've received in the past, as to what moving average length is 'better'. The answer is that it depends on your trading or investing horizon. A 5 to 8 or 9 length setting will be useful in seeing changes in the short-term trend. 13 on up to 21 will highlight changes in the intermediate trend of 2-3 weeks or longer; I most often use 21-day moving average to track the 2-3 week trend in the stock indexes.
What moving average length 'works' best in individual stocks in terms of highlighting support and resistance points varies. You have to play with the numbers as you get to know the stock. By the way, 'changes' in the trend refers not only to possible trend reversals, but also to an acceleration of the trend relative to the moving average. 50 and 200-day simple moving averages are probably the most used moving averages in stocks and stock indexes by investors.
You may see a 'default' number in moving average studies as a number like 9 and you need to change the setting (the length input) to what you want. I prefer a 21 length setting on hourly charts as a means of tracking the 2-3 day trend.
Use of 21 is explained by my fondness for using 5, 8, 13 or 21, part of the fibonacci number series; i.e., the number series 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, etc., where each number is the sum of the prior two numbers. I tend to use 8 as my length for moving averages on weekly and monthly stock and index charts and a 21-day (or hour) moving average on daily (and hourly) charts.
For the intermediate or secondary stock trends, there is little question that the 50-day moving average or 10 weeks (5 trading days in a week: 10 X 5 = 50), reflects a 'convention' for length that is very common for stocks. The reason for this is particular length, versus some other, is partly a convention but also may reflect the fact that 50 is 1/2 of 100 in terms of days, and 1/10 of 100 in terms of weeks. 100 and its fractions and multiples, is a significant number in our decimal system and in trading. I suspect also that 10 weeks is simply long enough to 'capture' the trends in the market that are of intermediate or secondary trend duration.
For displaying or capturing the long-term (major) trend, the 200-day moving average wins hands down as the favorite Simple Moving Average, the most common type of moving average. The 200-day is used or noted daily or weekly by many investment-oriented stock market participants. Some chart books and commentators refer to equivalent average in weekly terns, as the 40-week moving average.
Examples of these common moving average lengths are seen in the next 3 charts.
The 50-bar SMA:
And, the 200-day SMA:
My last chart is an example of a 40-week moving average on a longer-term weekly chart and equivalent to a 200-day moving average. When changing time periods from daily to weekly, you need to remember to change the moving average length setting to view the equivalent trend on a weekly chart.
Leaving the values and just switching time frames may be of interest also, but then you are comparing 'apples and oranges', so to speak. A 50-week moving average encompasses almost a full year rather than the 10 trading weeks measured by the 50-day moving average.
Many analysts, traders and money managers define the long-term trend by whether a stock or an Index is trading above or below its 200-day (40-week) moving average. The secondary (stock market) trend can be defined so to speak by a similar use of the 50-day (10-week) moving average.
If you were buying a stock for a long-term 'buy & hold' that had been in a down or sideways trend, a 'minimum' requirement might be a Close above the 50-day moving average. More conclusive is a close above the 200-day moving average. I suggest also exploring the use a combination of these two moving averages. For example, buying a stock on an initial upside penetration of the 21 or 50-day moving average, especially if there are other bullish chart considerations (e.g., a breakout above some key trendline), but only taking one-half of the number of shares of a usual purchase. A further purchase could be made on an advance above the 200-day moving average.
GOOD TRADING SUCCESS!