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By Casey Murphy, Senior Analyst ChartAdvisor.com
Data Used in Calculation
Most moving averages take the closing prices of a given asset and factor them into the calculation. We thought it would be important to note that this does not always need to be the case. It is possible to calculate a moving average by using the open, close, high, low or even the median. Even though there is little difference between these calculations when plotted on a chart, the slight difference could still impact your analysis.
Finding an Appropriate Time Periods
Because most MAs represent the average of all the applicable daily prices, it should be noted that the time frame does not always need to be in days. Moving averages can also be calculated using minutes, hours, weeks, months, quarters, years etc. Why would a day trader care about how a 50-day moving average will affect the price over the upcoming weeks? On the other hand, a day trader would want to pay attention to a 50-minute average to get an idea of the relative cost of the security compared to the past hour. Some traders may even use the average price over the past three minutes to gauge an uptake in short-term momentum.
No Average is Foolproof
As you know, nothing in the financial markets is for certain - certainly not when it comes to using technical indicators. If a stock bounced off the support of a major average every time it came close, we would all be rich. One of the major disadvantages of using moving averages is that they are relatively useless when an asset is trending sideways, compared to the times when a strong trend is present. As you can see in Figure 1, the price of an asset can pass through a moving average many times when the trend is moving sideways, making it difficult to decide how to trade. This chart is a good example of how the support and resistance characteristics of moving averages are not always present.
Responsiveness to Price Action
Traders who use moving averages in their trading will quickly admit that there is a battle between trying to make a moving average responsive to changes in trend while not allowing it to be so sensitive that it causes a trader to prematurely enter or exit a position. Short-term moving averages can be useful in identifying changing trends before a large move occurs, but the downside is that this technique can also lead to being whipsawed in and out of a position because these averages respond very quickly to changing prices. Because the quality of the transaction signals can vary drastically depending on the time periods used in the calculation, it is highly recommended to look at other technical indicators for confirmation of any move predicted by a moving average. (For more on various indicators, see Introduction To Technical Analysis.)
Beware of the Lag
Because moving averages are a lagging indicator, transaction signals will always occur after the price has moved enough in one direction to cause the moving average to respond. This lagging characteristic can often work against a trader and cause him or her to enter into a position at the least opportune time. For example, the only way for a short-term moving average to cross above a long-term moving average is for the price to have recently moved higher - many traders will use this bullish crossover as a buy signal. One major problem that often arises is that the price may have already experienced a large increase before the transaction signal is presented.As you can see in Figure 2, the large price gap creates a buy signal in late August, but this signal is too late because the price has already moved up by more than 25% over the past 12 days and is becoming exhausted. In this case, the lagging aspect of a moving average would work against the trader and likely result in a losing trade. Check out the next section of this tutorial to learn about trading strategies involving moving averages.
Next: Moving Averages: Strategies »
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