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Moving Averages That Work
Of all the things that are written about in trading probably the most common is the Moving Average. It is the starting point for most tutorials and the hope of every new trader that he will find a moving average that he can apply to a chart and that will make money.
What Is A Moving Average
A moving average is simply the average number
of a given sequence of numbers. If you have 5 numbers in
a sequence e.g. 4,8,6,4,7 the average is 5.8; you get this
by first adding all the numbers in the sequence and then
dividing that number by the amount of numbers in the sequence.
The table above is a 5 period simple moving average. The average of 9263.21 is the average of the previous 5 closes.
If you were to see this on a chart it would look like this.
Here's the problem with a lot of moving averages. The average you use may not be representative of the market as it actually is.
Let's say you have 5 cars in a parking lot. 4 of the cars are worth $10,000 and the other one is worth $50,000. The average of all the cars is $18,000 right. But is that a fair representation of all the cars in the lot?
Most of the cars are $10,000 but because one car is aberrantly
priced it effects the whole average. The same is true of the
markets. You can sometime have a huge move in the market that
effects the moving average and because you may for example
be using a 5 period moving average it will effect the average
for the next 5 days even though the next 4 days may have a
very small range. You won't see an accurate refection of the
market until the sixth day when the large range day drops
Types Of Averages
Simple Moving Average
Weighted Moving Average
Exponential Moving Average
The exponential moving average is similar to the weighted moving average inasmuch as it places more emphasis on recent data. Typically a % of the most recent data is calculated and deducted from the previous data in the sequence.
There are many other types of moving averages but the above are the most common. It is interesting to note that in all the studies I have read there is no significant difference in the type of moving average used over time. The longer the look back period the less difference there is in the moving average.
The main problem I have found with new traders is that they will use a moving average for entry signals regardless of market conditions. Moving averages are best used for trending markets. Using moving averages in a market that is in consolidation will most likely lead to loss.
First let me tell you that displaced moving averages are
not the Holy Grail. They have however helped me a lot in my
The great advantage of this is that you will know what average you are using in advance. If you are using a 3 period moving average displaced once then you will know the moving average you will be using tomorrow before tomorrow comes.
In the chart below there are two moving averages. The black line is a typical 20 period moving average. The green line is a 20 period moving average displaced 5 times into the future.
You can see that in this up trend there are fewer closes
below the green line thus keeping you in the trade longer.
With less whipsaw you don't get kicked out of the trade as
There are an infinite number of combinations you could use with displaced moving averages. Experiment for yourself and have some fun with them. When I use moving averages I always use a displacement. I find it just mimics the trend better.
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