Link: Thoughts on Moving Averages

Apr 14, 2007: 5:25 PM CST

I absolutely use Moving Average analysis in my trading, and – although there are hundreds of articles that address the topic – I found two recent posts in the blog world to be interesting to me.

First, let me preface: Moving averages – like every other indicator – “work” because people respond to them, and when people do so in aggregate, the combined imbalance “causes” them to “work”. Moving averages work best in trending markets, and can be used to define a low-risk entry into a trending market (following a pullback).

Here are a few quotes from an article from the DayTradeTeam:

“One of the biggest reasons moving averages are so popular as trend-following systems is that they embody some of the oldest maxims of successful trading. They trade in the direction of the trend, and moving averages let profits run and cut losses short. These principles of the moving average force the user to obey the rules by providing specific buy and sell signals.”

Richard at MoveTheMarkets posted an insightful analysis arguing against “magic moving averages,” and the entire post is absolutely worth a read for deeper study. I have included a few quotes:

  • Math doesn’t support stocks – people do.
  • The only reason moving averages work at all is because enough people are using them as guidelines.
  • Most stocks are just too fickle to trend along a single intraday moving average for long.
  • People support stocks. That also tells me that there’s no reason to tie yourself down to any “magic” moving average period.

I have learned that Richard is right in my experience. In the past, I used to enter trades because of a pullback to a key moving average and place my stop right below them. Invariably, I would get stopped out right before a major move and then curse the market makers, stock, or anything I could find for gunning me out.

I then realized that moving averages are not magic, and I cannot expect price to reverse the moment they touch the average without at least some wiggle. They can still be used for entries into a trending market, and they often work fine at this, but do not approach “moving average support” as an exact science. In fact, approach nothing in technical analysis as an exact science, but that it reveals probable tendencies of sometimes irrational people. Again, know why you take the trades you do and what the “trade idea” you are executing means.

If you don’t use moving averages for trade entry, you can still benefit by using them to identify a trend condition in the market. Identify whether or not price is above or below a major moving average. This adds information to your analysis. Some traders refuse to go long when a stock is beneath the 200 day moving average on the daily chart. Others use “Moving Average Ribbons” to identify the trend/range axis or picture of the market.

Again, don’t expect price to behave because a certain technical condition is met. Understand the reasons behind “moving averages acting as support” and what that might mean for you and your system as a trader.


3 Responses to “Link: Thoughts on Moving Averages”

  1. Jack Says:

    Corey, I am new to your site, thought I would throw in how I just used a MA for an exit. To stay with this trend I “fitted” the EMA to 8 periods. You can see it never closed below the 8 period EMA for many weeks that I held the stock. I got in at 16.80.
    Today I exited half my position below 20. I will hold the other half untill the previous weeks low is taken out. Both are profitable, one is for the shorter term (daily) and one is longer term (weekly) This helps me to hold the winners, let the market tell me what to do.

  2. Jack Says:

    Sorry here is the stock chart

  3. Corey Says:

    Hey Jack, Thank you for your comment.

    Indeed, you have a wise exit strategy that is effective there. Although twice the intraday movement traded below the moving average, it never closed below. Some traders insist on “two consecutive closes below a key MA” as their exit signal, so that they are not whipsawed, but of course this could lead to larger losses, so it is best to test this parameter before using it.

    It really is wise to find a system or strategy for letting winners continue to perform, and taking half the position off at certain times is often wise, provided a strong and confirmed trend (usually with fundamental backing) is established and traded.

    This strategy is passive and allows for minimal monitoring (and minimal decisions) which is very helpful for longer term swing and position trading. You’re also right in that the market is the “decider” (in terms of the average and the chart) and not the trader (subject to the ‘fear’ of losing profits).

    My best to you.