Moving averages
Moving averages
The advantages of using moving averages need to
be weighed against the disadvantages. Moving averages are trend following, or
lagging, indicators that will always be a step behind. This is not necessarily
a bad thing though. After all, the trend is your friend and it is best to trade
in the direction of the trend. Moving averages ensure that a trader is in line
with the current trend. Even though the trend is your friend, securities spend
a great deal of time in trading ranges, which render moving averages
ineffective. Once in a trend, moving averages will keep you in, but also give
late signals. Don't expect to sell at the top and buy at the bottom using
moving averages. As with most technical analysis tools, moving averages should
not be used on their own, but in conjunction with other complementary tools.
Chartists can use moving averages to define the overall trend and then use RSI
to define overbought or oversold levels.
Price Crossovers
Moving averages can also be used to generate
signals with simple price crossovers. A bullish signal is generated when prices
move above the moving average. A bearish signal is generated when prices move
below the moving average. Price crossovers can be combined to trade within the
bigger trend. The longer moving average sets the tone for the bigger trend and
the shorter moving average is used to generate the signals. One would look for
bullish price crosses only when prices are already above the longer moving
average. This would be trading in harmony with the bigger trend. For example,
if price is above the 200-day moving average, chartists would only focus on
signals when price moves above the 50-day moving average. Obviously, a move
below the 50-day moving average would precede such a signal, but such bearish
crosses would be ignored because the bigger trend is up. A bearish cross would
simply suggest a pullback within a bigger uptrend. A cross back above the
50-day moving average would signal an upturn in prices and continuation of the
bigger uptrend.
The next chart shows Emerson Electric (EMR)
with the 50-day EMA and 200-day EMA. The stock crossed and held above the
200-day moving average in August. There were dips below the 50-day EMA in early
November and again in early February. Prices quickly moved back above the
50-day EMA to provide bullish signals (green arrows) in harmony with the bigger
uptrend. MACD(1,50,1) is shown in the indicator window to confirm price crosses
above or below the 50-day EMA. The 1-day EMA equals the closing price.
MACD(1,50,1) is positive when the close is above the 50-day EMA and negative when
the close is below the 50-day EMA.
Moving averages smooth the price data to form a
trend following indicator. They do not predict price direction, but rather define
the current direction, though they lag due to being based on past prices.
Despite this, 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. The
two most popular types of moving averages are the Simple Moving Average (SMA)
and the Exponential Moving Average (EMA). These moving averages can be used to
identify the direction of the trend or define potential support and resistance
levels.
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