MOVING AVERAGES: CHARACTERISTICS AND GENERAL USES

By David Landry

In the first part of this series we looked at the calculation and differences between exponential, weighted and simple moving averages. In this second installment, we’ll look at the characteristics of moving averages and general uses.

Drop-Off Effect

In the first installment of this series, we discussed a set of hypothetical grades that a student earned. They were 67, 77, 80, 82, and 85. The average of these (67+77+80+82+85)/5 equated to 78.20. We then added in a new score of 90 and "dropped off" the old score of 67, thereby creating a five-day "moving" average. This is illustrated in Figure 1. Notice that the student’s performance jumped from 78.20 to 82.80. This, of course, was due in part because we added in a higher grade but is also attributed to the fact that we dropped off the oldest grade. This grade also happened to be the worst. Therefore, by dropping off the oldest data point, moves in the moving average can often be exaggerated. This is known as the "drop-off effect".

Figure 1. Simple Moving Average. The increase in the average from 78.20 to 82.80 was due, in part, to the older data being "dropped off".

The drop-off concept is better illustrated in a "real world" example. Referring to Ask Jeeves ASKJ in Chart 2, notice that the moving average increased by 2.21 (a) while the stock price actually decreased by 4 3/4 points (b). The fact that the moving average increased even though the stock price decreased was due, in part, to the fact that the older lower-level data was dropped off (c).

Chart 1 Ask Jeeves. The moving average continues to increase (a) even though the stock dropped in price (b). This is due to higher level prices being added to the average and lower level prices (c) being dropped off.

The drop-off characteristic is actually quite useful when trailing stops as the moving average catches up to the price. However, when used as a gauge for performance, this characteristic should be considered.

Reversion to the Mean

As I've joked in prior articles, if you know someone who's mean but then nice for a few days, chances are they'll revert back to being mean. That's the whole concept behind reversion to the mean (average). Therefore, reversion to the mean is simply a market's tendency to revert back to average levels once stretched to an extreme. Referring to Chart 2, December Bonds, notice that at points (a) through (g) the market reverts back to the average after being stretched. The problem is, you never know exactly how far "stretched" can be. Notice that at points (f) and (g) the market moved to more extreme levels before correcting. Nonetheless, the reversion to the mean characteristic is useful for determining if a market is due for a correction.

Chart 2 December 1999 Bond Futures. Prices have a tendency to revert back to the mean (average). Notice that once stretched, points (a) through (g), the price tends to revert back to the average.

General Uses of Moving Averages

Now that we've defined the characteristics of moving averages, let’s look at general ways to use them. Conventional wisdom states that you should buy a market when the fast (short-term) moving average crosses above the slow (longer-term) moving average and sell that market when the fast moving average crosses below the slow moving average. Unless you're fortunate to catch a market right before a large trend (and subsequently quit following this "system"), you will more than likely lose money with this approach *. This is illustrated in chart 3, the cash S&P index. Notice that following this method would occasionally catch a big trend (points (b) and (c)) but more often than not you would lose money during the market’s whipsaw (points (a) and (d)). I’m not saying that crossovers are completely worthless. My point is that they should be used as a reference only and not as a purely mechanical system in and of itself.

Chart 3, Cash S&P Index-Using Moving Average Crossovers as Trading Signals. Large trends such as points (b) and (c) are occasionally captured by using this system. However, for the most part, the system will lose money due to the market’s whipsaw (points (a) and (d)).

Slope of moving average

One of the least complex and possibly most useful ways to use a moving average is to simply look at its slope. If the slope is rising then the market is in an uptrend. On the other hand, if the slope is falling then the market is in a downtrend. This is illustrated in Chart 4, March 2000 Coffee. Keep in mind that you can’t really base a system purely on this approach but trading with the trend based on the slope of the moving average may help keep you out of trouble.

Chart 4, March 2000 Coffee-Using the Slope of the Moving Average to Gauge Performance. Although you probably can’t base a system solely on the moving average slope, a positive slope suggests an uptrend while a negative slope suggests a downtrend.

Using the Moving Average for Support/Resistance & Reference Points

Markets will often find support and resistance at the moving averages. For instance, if a market is in an uptrend and begins to correct, it should not trade below its immediate term moving average. For example, in stocks, the 50 day moving average usually provides a good point of reference as it is watched by large traders and institutions. Stocks should stay above the average and find support there during corrections. This is illustrated in Chart 5, Cisco Systems. On the other hand, in downtrends they should find resistance at the moving average during relief rallies.

Chart 5, Cisco Systems-Using the Moving Average as a Reference for Support. Notice that the stock finds support at or near the 50-day simple moving average.

Looking Ahead

Now that we've defined the different types, characteristics, and uses of moving averages we’re ready to look at more specific strategies involving moving averages. In our third and final installment on moving averages, we’ll look at specific strategies involving moving averages.In their defense, moving average crossovers did seem to work before the widespread use of computers. You should, however, be suspect of any newer books which discuss the technique as a viable mechanical system.

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