I write at Yahoo on Moving Averages:
In trading circles, much is made of the move of the longer term averages to below “200 DMA” or the 200 day moving average. So what is it?
Firstly, the moving average (MA) is a “technical” term — meaning, something that derives from the price or volume alone, not looking at the underlying fundamentals of a company. Prices, after all, are the only real indicator of what has happened, and prices are driven quite by sentiment —sentiment that is recognizable in patterns in traded prices. Technical analysis is just the field of understanding such patterns.
A moving average help us smoothen daily price changes to give us a picture of a trend and context. Mathematically a moving average is simply the average of the last “n” days; so a 200 day moving average is the average of closing prices of the last 200 days.
Why is it “moving”? Every day the average changes, because it looks at the past 200 days; in effect, as newer prices come in, the oldest prices are moved off the calculation.
Why “200”? The number of periods in a moving average depends on the timeframe you want to look at. 200 days is considered a reasonable indicator of a long term trend; 50 days medium term and 20 days, short term. Moving Averages are a lagging trend indicator; that is, they tell you about a trend after the trend has begun; as prices move up, the higher prices bump the average only after the older, lower prices fall off. One way to reduce this lag is to give more recent prices a higher weightage in the calculation — enter the “Exponential Moving Average” (EMA). Another set of traders believe that prices with heavy volumes are more important because they give a better idea of crowd sentiment; they would look at a Volume Weighted Moving Average (WMA).
Going very long term — 1000 day MA, for instance — are counterproductive. By the time it’s indicated a trend, the trend is probably over. On the other hand, doing a 2 day moving average is useless — two days isn’t much in terms of “smoothing”.
How do you use it? Moving averages or MAs give you the current trend of a stock. An upward sloping MA is considered an uptrend, downward slopes downtrends, and flat MA lines as “going nowhere”.
In a downtrend, you find the MA lines going the other way:
And finally, nothingness.
So you’d buy the uptrends and sell the downtrends? With a lagging indicator, you might have already missed the bus if you take the slope. Some investors use the MA as a “trigger” to buy or sell: When the prices cross over from above to below an MA, it’s a buy, and in the other direction, a sell.
Yet others think that the MA forms a “support” base — so they might buy on the belief that the price is expected to go back up after dropping down to the MA. One of the two wins each battle.
There is also a school of thought that prices themselves are too volatile — they will cross up and down too often causing unnecessary whipsaws. They choose to act according to two MAs — for instance the 20 DMA crosses over the 50 DMA is considered a buy signal. In fact, the 50-DMA/200-DMA cross is considered a “Golden” Cross, an indicator that price trends have finally changed.
Why do trends matter? Because when prices go up in a trend they tend to keep going up. An active investor would be wise to trade in the direction of the trend — that is, buy when the markets are in an uptrend and ignore (or go short) when they aren’t. Of course at this point, it doesn’t seem like that strategy is useful, because our stock markets are near all time highs (sure, we dropped 15%, but still). You would have done well to have bought every dip in the markets, trend or not. But today is not tomorrow, and markets abroad have shown that a downtrend can be really long term in nature Look at Japan, for instance, with its markets way below their 20-year-ago figure — and if you think we aren’t a Japan, consider that 20 years ago, Japan had the exact image that India and China have today, of an upcoming world power. Even downtrends sustain — you will see commodities go through strong multi-year trends in both directions.
It’s not just your view of the future that matters, it’s also that markets are saying the same thing. Yet we hear often of people who made enormous sums of money betting against markets, from a John Paulson who bet against subprime, to a Warren Buffet who bought even more when prices fell down. These are heroes, no doubt, and examples of when we should break the rules; but in the short term — which these two players in particular may have no appetite — sentiment matters more.
Moving Averages are usable with any stock or commodity with reasonable volume. When you look at prices, it doesn’t matter if you’re working with a Reliance or with Silver futures; the concept is the same.
While technical indicators like MAs help us understand such mass sentiment, they are prone to self-fulfilment. If enough traders follow the moving average crossover rules, prices will follow.
Sometimes I wonder if I follow technical indicators because I staunchly believe in them, or because I believe enough other people are following them. Regardless, I have found that losing sight of technicals causes much more pain — you may find a great story to buy, but it’s always better to buy them after the market “discovers” them and puts them on that uptrend.
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