Markets constantly evolve. Most of the patterns we have examined thus far require set price points. While identifying key prices is important, we would like the flexibility to adjust as prices move. This brings us to the next technical tool—moving averages (MA).
As the name indicates, moving averages look at trailing price data to identify trends. Doing so allows the flexibility of incorporating current information without the burden of deciding which specific points carry the greatest weight. By smoothing out an average, we can let the picture develop and trade accordingly.
There are many ways to apply moving averages to your trades. To get started, follow these five key guidelines:
1. Know your type – Most people will use a simple moving average (SMA). This approach averages all price points equally over a given time period. To take a 20-day SMA we would look at the last 20 days’ prices, assign each a weighting of 5%, and calculate the average. This is the process I prefer as the data remains pure and I do not influence the outcome. However, some traders believe recent data should receive precedence and weight those numbers more heavily. Whichever approach you choose, make sure you understand how the numbers are calculated.
2. Time – We can calculate MA using any time period. Generally, longer time periods work better for trends while shorter time periods are used for reversals. As the US Oil Fund (USO) chart shows, longer MAs have less volatility than shorter ones.
3. Trading systems – A popular trading approach is to use MAs within the double crossover method. This strategy entails buying an item when the shorter MA crosses above the longer and selling when the shorter falls below the longer. Applying this to USO would have resulted in large gains as the trader would have sold at the red arrow and bought at the green arrow.
4. Envelopes – Another approach is to draw trading bands, or envelopes, based on a percentage move from the existing MA. USO shows a traditional 20-day MA with 2.5% envelopes. When the price hits the higher level we sell, and when it hits the lower level we buy. In trending markets this process works well. However, when prices move sharply, envelopes fail.
5. Creativity – MAs offer a great way for us to experiment. Since MAs that are too short often cause false signals and those that are too long miss key reversals, we are encouraged to apply creative thinking and determine which approach works best.
In trending markets, MAs offer an excellent way to trade effectively and increase returns. Learn these guidelines and your chance for success increases.
Sean Hannon, CFA, CFP is a professional fund manager.
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