A moving average is an indicator derived from the average price of a security over a specified period of time and is applied to charts to follow market trends as securities move up and down. In addition, support and resistance levels (where the price of a security reversed its upward or downward trend in the past) can sometimes be established by monitoring moving averages over time; these points are then used to make buy or sell decisions. However, moving averages are rarely effective as standalone tools because of at least seven disadvantages.
- A moving average is a technical charting indicator based on averages of past price movements.
- Common moving average time frames include 20, 50, and 200 days.
- Moving averages are used to identify trends and potential support/resistance areas.
- Like most forms of technical analysis, moving averages are based on past price moves and do not forecast the future.
Moving Average Disadvantages
Moving averages are available with many charting applications and offer a quick, easy way to see trends in a stock, commodity, or market. Common time frames for moving averages include 20, 50, and 200-day moving averages. Technical analysts also use moving averages to identify potential changes in trend. For example, a "death cross" pattern happens after a stock has moved higher, begins to move lower, and the 50-day moving average crosses over the 200-day.
While moving averages are widely used by investors and traders alike, the indicators are far from perfect:
- Moving averages draw trends from past price information only. Like any type of technical analysis tool, chart indicators don't take into account changes in fundamental factors that may affect a security's future performance, such as new competitors, higher or lower demand for products in the industry, and changes in the managerial structure of the company.
- Ideally, a moving average will show a consistent change in the price of a security over time. However, since every asset has unique price histories and levels of volatility, there are no uniform rules that can be applied across all markets.
- Moving averages can be spread out over any time period and this can be problematic because the general trend can be different depending on the time period used. For example, what appears to be an uptrend using a 50-day moving average might be part of countermove in a downtrend that is reflected in the 200-day moving average.
- An ongoing debate is whether or not more emphasis should be placed on the most recent days in the time period (such as with exponential moving averages). Many feel that recent data better reflect the direction the security is moving, while others feel that giving some days more weight than others incorrectly biases the trend.
- Some investors argue that moving averages (and other forms of technical analysis) are meaningless and do not predict market behavior. They say that the market has no memory and that the past is not an indicator of the future.
- Securities often show a cyclical pattern of behavior that is not captured by moving averages. That is, if a market is bouncing up and down a lot, moving averages are not likely to capture any meaningful trends.
- The purpose of any trend is to predict where the price of a security will be in the future. However, if a security is not trending in either direction, it doesn't provide an opportunity to profit from either buying or short selling.
The Bottom Line
Many traders and investors rely on moving averages to identify trends and support/resistance levels, but for an indicator to be effective, its function must be understood: when to use it and when not to use it. The perils discussed herein indicate when moving averages may not be effective tools, such as when used with volatile securities, and how they may overlook certain important statistical information, such as cyclical patterns.
Given the drawbacks, moving averages may be a tool best used in conjunction with other indicators and analytical methods. In the end, personal experience will be the ultimate indicator of how effective moving averages truly are for your portfolio.
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