What You Need To Know About One Of The Most Popular Charting Tools
Moving averages (MAs) are one of the most popular trading tools. They’re simple and easy to understand. Before there were calculators or computers, traders found simple 10-day moving averages by adding up the last 10 closing prices and moving the decimal point one space to the left.
Now, MAs of any length are easy to calculate and widely used. We also have variations of the simple calculation. Rather than just adding up numbers and dividing by the total number, there are at least four other possible ways to find a moving average:
1. Exponential Moving Average: Assigns a greater weight to the more recent market action in an effort to be more responsive to changes in the trend.
2. Weighted Moving Average: Allows users to decide which data should be overweighted and allows for the weighting values to be changed.
3. Triangular Moving Average: Weights the middle of the data more heavily.
4. Adaptive Moving Average: Uses smoothing factors to adjust the number of days used in the calculations to current market conditions.
How Traders Use Moving Averages
Each method has its proponents. And each of the four methods adds a level of complexity to what was originally a simple indicator. Complexity is only OK if it adds value. Visually, it looks like the different moving averages move in the same general direction.
The chart below is a weekly historical chart of the SPDR S&P 500 ETF (NYSE: SPY) with several different moving averages overlayed on the chart. For demonstration purposes, we’ve removed the legend identifying which colored lines are which moving averages.
The point is that you can see the moving averages rising and falling at the same time. Some moving averages lag the simple moving average (thick blue line) at some points while delivering timelier signals at other points. Yet others tend to consistently lag (or lead).
The point is, based on the visual comparison, we can say that the averages are all close to each other. More detailed quantitative testing of the various MAs is required to develop a stronger opinion as to which one is best.
Ultimately, it’s up to you whether you want to rely on more advanced forms of moving averages or not.
Why Moving Averages Matter To Traders
Large delays at bottoms are one of the most significant drawbacks of trading with a moving average. The other significant drawback is that there are a large number of small trades in a sideways market.
In our experience, using MAs for bearish short trades can lead to large losses. We prefer using MAs for long-only trades, moving to cash when prices fall below the MA.
For example, back in March of 2020, traders could have used the adaptive MA for the SPY as a warning sign to get out of the market. As you can see in the chart below, when SPY broke through on the downside, it fell much, much further. (Similarly, it could have been used as a sign to get back in, as traders would have only missed a small fraction of the rebound.)
Again, however sophisticated you want to get with MAs is ultimately up to you. Just know that MAs will not call the top of the market. In fact, because it is calculated with historical data, it is impossible for any MA to signal at the exact top or bottom.
There is no way to fully eliminate the problems associated with moving averages. But the best way to use them is to apply MAs as a long-only signal. No matter what type of MA is used, when the prices are below the MA, the chances of profitable buys are low.
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