Trading With Moving Average
As an investor, you always seek to understand what other traders think and how they will act. The moving average is one of the best technical indicators to answer this question. This makes moving average one of the most common methods of trading and the basic indicator in most automatic trading platforms. One of the very big advantages of moving average is how easy it is to understand and use. This makes it easy to include into any trading strategy you may have, as it simply is; buy if moving average is under price line, and; sell if it goes above. However, despite being easy to use and understand there are few things you need to know if you want to utilize it the full potential of moving average. If you use it blindly you will find yourself popping in and out of shares without really making much money. In the worst case, your popping in and out will make you lose even more. If it is that easy to make money on moving averages, why doesn't everyone use it and become billionaires? The answer is always the same; if something sounds too good to be true, it probably is. Only a few really master the trading with moving averages, but most traders should be able to cut their losses substantially just by knowing a little about moving averages.
Moving average - then intent
The first use description of moving average is honored R.H. Hooker (1901) and published as “instantaneous averages” in Journal of the Royal Statistical Society, by G.U Yule in 1909 (Journal of the Royal Statistical Society, 72, 721-730) and in book form by W.I King in 1912 (Elements of Statistical Method). But the fact is that moving averages had been used in decades. Moving averages belong to the grouping: Time Series Analysis and can be applied to anything that holds a defined (time) series data. Technically moving average is a way of smoothing out the price based on history. The reason for this is because we seek a way to predict the future and we use history to do so. By smoothing the price we reduce noise. You may consider noise as a distraction like for instance news that gets a strong impact on the stock when released. More than 1 person has lost his/her money while jumping on an intraday rocket just to slam to the ground the following day because the news has no real impact on the share value. In fact, un-serious brokers, companies, and traders may often use “news” as part of their pump and dump tactic or damage control. No one is better than Teslas', Elon Musk. He pushed comments and news just before bad quarterly results and was fined USD 20 million (in late 2018) for news made up, while high on a joint, about south Arabic investors offering premium prices. And his joint stunt did the work it was supposed to do... The reason we want to reduce noise is based on the same principle and psychological factor as we turn the head if a police car drives by with sirens on. Noise attracts our attention and we lose focus. Moving averages can be considered as dynamical trends trying to say something about the general direction. Noise is smoothed out and the length of the smoothing defines if it is a short term or long term signal. If the price is under the moving average there is a general sell signal and when above there is a buy signal. It is very popular to use the abbreviation MV for moving average, where the following number describes the days of smoothing (e.g. MV35 means moving average smoothed over 35 days).
Moving average - the understanding
When we apply moving average in the trading we buy shares if the price goes above the moving average and sell if it goes below. Here we see the price as an indicator of behavior. Price going up or down indicates the level of investor optimism. Still, we want to reduce the noise, like news, erratic behavior to get a more correct view of the general direction of the stock and what the most current action indicates. To do this we make a benchmark (moving average) and use this as a baseline. If the price is going up above the moving average this is indicating that the investors are getting more positive and this will likely push the price higher in the short term. If the price goes below the moving average it indicates a negative change. Moving average crossing price line can be considered as a switch or early warning, and it is this knowledge you trade on.
Facebook stock price (FB). The light blue line is a 7-day moving average and the dark blue line is 35 days moving average. The red and green circles just illustrate the way you trade using a moving average. However, there is more to it than just buy and sell as price crosses the MV line. You will quickly learn that moving average is very reliable for some stocks, and not at all for other stocks. It even depends on the current market situation and you will have to decide what time (smoothing) factor should be used? For some stocks, you will need longer or shorter smoothing periods depending on the stock volatility and it will be highly reflected in your trading horizon. As a thumb rule, you will use longer smoothing for the longer trading horizon you have. Furthermore trying to use moving average as a buy strategy on stocks in a falling trend is close to hopeless unless there is enough volatility as for example in the FB chart above. The stock is in a generally weak falling trend but is moving so much up and down (volatility) that there are obvious trading opportunities. To avoid digging too deep into it we can assign 3 very important elements to the moving average strategy.
[ VOLATILITY ] How volatile is the stock you are trading?
[ TIME ] What time length is used when calculating the moving average?
[ LIQUIDITY ] How reliable is the moving average?
Since moving average is just an average it also becomes clear that eventually, it will get back to the price line. If the stock is traded every day @ USD 5 the moving average will become USD 5. Having a buy from moving average (price above the MV line) is not an indefinite situation. In trading perspective, this means you - in order to optimize the outcome of the signal - need to get out of the buy or sell position before the moving average goes back to the price line and flip to the opposite signal.
But let us start with VOLATILITY and the first rule:
Volatility will affect the use of moving average as a trading tool.
Volatility can be seen as a risk and is visualized by how much the stock turns up or down. If the stock fluctuates much during a trading day the stock has high intraday volatility. This can be measured looking at the price high and price low during a day. There are many stocks out there that have intraday fluctuations above 5%, but still low daily volatility. For intraday traders, these are perfect trading stocks and they will use moving average on intraday data. Another measure is a day to day volatility, weekly, monthly and even yearly. As I have mentioned several times volatility equals risk. Trying to use moving average when trading with penny stocks is almost a guaranteed way to lose your money. At the same time, you need some volatility to trade efficiently using moving average. This is where liquidity comes to our aid: good general liquidity usually equals less risk. And by that, I do not mean good liquidity for a day or two, but merely refer to the size of the stock/company.
The second rule is:
Liquidity (volume * price) will tell you information about the risk. The higher the liquidity the more reliable the moving average is.
Time is extremely important. This is where money is made and lost. Time is indeed relative and you need to think about time as a concept. To this concept, you will add the proper moving average that fits your trading strategy, the stock(s) in question and the volatility of the stock(s). Time as a concept is the result of 2 factors: your trading horizon and the behavior of the price. To give some examples: if you are a short term trader using MV100 is not your interest. And if the stock is just steadily going in one direction (behavior) you will have to use a longer moving average than you normally would.
In the picture above you can see how a simple moving average is calculated. In this example, 3 executive days are added together and divided by 3. The abbreviation would be MV3. For the common stock trader, the most used MV’s are; M7, MV35, MV100, and MV200.
There are some formulas made to calculate the best moving average to use and the introduction of machine learning (ML) will help optimize tremendously. Most charting programs offer some sort of ways to select moving average or use the best average based on statistics. There is nothing wrong in using several moving averages at the same time and if you keep a nice spread they will give initial signals you can play with. I will get back to that in the next section. The moving average of 100 and 200 are most widely used for long term trading.
Some key notes:
Do not use moving average as a buy signal if the stock is within a falling trend. Go play some bingo instead. In falling trends, use moving average for shorting.
Do not use moving average as buy signal if fundamental news has been dropped as this will disturb the moving average unless you smooth it long enough.
Playing the moving average strategy without understanding that you have to beat a zero-sum game is like taking the zip line without a safety belt.
Moving average - digging into the nuances
For the more advanced trader, there are more secrets to be revealed. One is the many different ways of calculating moving averages. So what should you use? Simple moving average [SMA] or weighted moving average [WMA]? Perhaps a more complex method? Using moving average is working with statistics and please do remember, that all statistics pointed Hillary Clinton to win, while Donald Trump did win. The same is with moving average. It may indicate something, but the outcome is totally different. A lot of this has to do with not taking into account variables and being bias. The variables we already discussed a bit, things like time length, volatility etc. To avoid the bias you should find a method of how to select what kind of moving average you should use and rules for the smoothing length. This does not have to be advanced. It can be based on e.g liquidity and as simple as “for stocks with average liquidity less than 1 million per day I will use MV35” or “for stocks with more than 5% daily volatility I will use a weighted moving average”.
Below there are two attached images for different moving averages in a period for 3 months for GoPro. [GPRO]
In those images, you can see 8 different ways of calculating moving averages and the returns that are given from each method. In the first example we use MV7 (Moving average for 7 days) and in the other MV35. By first eyesight, it looks like you should always use MV7 (40%+ vs 30%+). However, never underestimate the difference in risk when you have to do 9 trades instead of 2.
Below is a picture showing other ways of using moving averages. In this specific case from our hausse indexes, we use buy signals issued from MV35 as a measurement of the market situation. The chart is the results of the MV35 signal from more than 7.000 shares and shown in percent. As image show the investors are getting more and more positive. At some point, you reach a level where too many investors are positive and liquidity is limited. In other words, at some point, you run out of money and the next option is to sell.
Moving average - The Death Cross
If we define moving average as the investors level of optimism and divide this into short term, medium term and long term investors we get the option of looking at the differences between them. This relationship between short and long term moving averages gave birth to the notorious death cross that has appeared in all major stock market setbacks, starting with the major crash of 1929.
The death cross appears when a short term moving average passes down under the long term moving average. It is an established truth that death cross should be based on MV50 (short) and MV200 (long), but this is a truth with large modifications. Furthermore, as Jeff Cox in CNBC points out in the article “Looks like the 'Golden Cross' isn't so golden after all”. Golden Cross is the opposite of the Death Cross and as Jeff Cox points out, when measuring all established crosses from 1969 to 2012 there is proof that the signal has any real value. So how come, it seems to be a perfect signal sometimes, but not all times? The answer is the same as the reason why people keep losing money on stock trading; you follow an idea blindly. And as I pointed out in the previous section you will need to adjust and adapt. Who said 50/200 is the correct way to measure 50 years? There might be a long sideways period and lack of volatility making signals flip in and out, but this does not make the signal less valuable. Moving averages are very good signals if used correctly.
If we look at the image above which represents a Golden Cross (the opposite of Death Cross), it is obvious that the return of the signal is poor, even creating a loss. That is why, as stated earlier, you should not use moving averages as a buy signal in falling trends unless there is enough volatility. It can be an indicator to make you on the alert and use other signals to verify possible changes.
Moving average - The Golden Star
I have always been a fan of the moving averages as it is truly helpful when timing entering and exiting points in stock positions. I always wanted to optimize the use of the signal, either by finding ways to set proper moving averages based on the individuality of the stock or by narrowing it to use statistics (backtesting). In 2005 I came up with the idea to try to strengthen the Golden Cross signal by adding a condition to it. After a lot of backtesting and actual trading, I ended up with my version of the Golden Cross - “The Golden Star”, which was first released on the website Getagraph.com. One of the conditions I added was the need for the Golden Cross to appear in the price line as illustrated in the graph below.
This signal has turned to yield far better than the Golden Cross and if you add other conditions like liquidity, time and volatility you get a very tradeable signal. Today the signal is only accessible @ StockInvest.us.