“Trade with the trend” is a long-standing trading rule that seems simple enough to follow. All you have to do is find the trend, trade in that direction and you’ve got a winner — if you spot it soon enough, if it moves far enough after you’re on board, if you exit at the right time…
If you look at a price chart, you may be able to see a trend, a channel, a breakout and other visual evidence of where the market has been. But, a computer can’t “see” the trend the way your eyeballs can. It needs something more mathematical and precise. For years, that something has been a moving average, one of the most common and familiar indicators for trend-following traders and systems.
A moving average is simply an average of prices for a given period that changes as each new price enters your time window. It is a lagging indicator based on past prices, but you can doctor it up in various ways to try to capture a trend early in its development. You can choose the price you use — close, average of open-high-low-close or even something other than price — the number of prices or the length of period in the average, the number of averages you use together and the type of average.
Simple moving average: An average of a selected number of prices, each treated the same. When you get a new price, the oldest price drops off and you divide the new sum of the prices by the number of prices to get a simple average.
Weighted moving average: The most recent price is perceived to be more valuable than the oldest price in the series, so it gets more weight. You can use your imagination in varying the weights, but you might multiply today’s price by five, yesterday’s price by four, the day before yesterday’s price by three, and so forth, until the oldest number in your average has the least weight.
Exponential moving average (EMA): Like the weighted average, an EMA gives greater weight to the latest price, but, unlike simple and weighted moving averages, it does not drop off the oldest price in the time span selected. An EMA is influenced by virtually all the prices in the contract’s history, using a constant that smoothes the average. The formula for the constant is 2/(length of moving average + 1). In a 10-day EMA, for example, the latest price is weighted at 18% of the total instead of 10% — as it would be in a simple moving average.
The chart of the Japanese Yen prices shows how these common moving averages compare. Note that the 50-day simple moving average just keeps moving in a slow curve down and then up from May to September; whereas, both the 50-day weighted and 50-day EMA respond to the price rally in August more quickly and track the current price more closely. These more sensitive averages can give you a signal that gets you into or out of a position a day or two earlier than a simple moving average.
Fortunately, with today’s technical analysis software packages, you don’t need to make any moving average calculations manually. All you need to do is plug in a number for the length of your average and see what happens.
Of course, you still have to determine how the moving average is going to generate your trading signal. Typically, when prices cross above or below the moving average line, traders have used that as the precise point for their trading system to buy or sell. But you might require the close to be above or below the moving average, you might want the price to exceed the moving average by a certain percentage, you might use a moving average of highs or lows to form a price band…in short, you not only have lots of choices for building a moving average but also many ways to use this most flexible technical indicator.
Next article: MACD using several moving averages
