Moving Average Basics II

Apurva Sheth
Last time I spoke to you about how a moving average is calculated and two most popular types of moving averages simple moving average (SMA) and the exponential moving average (EMA).

The main purpose that a moving average serves is to determine a trend. However, moving averages cannot foretell about the change in trend. They will signal a reversal only after it has actually occurred. This happens because a moving average is created based on the past price information.

For example if I am plotting a 20 day moving average then it will smoothen last 20 days price action and give me a number which is an average of those 20 days. This number will be somewhere closer to the tenth day in this series. So basically I am using a number which is quite historical to trade ahead in time. This is why moving average is known as a Lagging Indicator.

Though moving averages are lagging indicators this does not undermine their importance. After all they allow you to be in the trend as long as it is valid. But the only dilemma with this is to choose a time frame which keeps you with the trend and give you quicker signals of a reversal as well.

Unfortunately, both these goals cannot be met at the same time. There has to be a tradeoff between both and so choosing a decent time frame for your moving average becomes important.

If a trader’s preference would be to stay with the trend then he would choose a slightly longer time frame for his moving average as that would smoothen more data. On the other hand if his preference is for quicker signals of a trend reversal then he would choose a shorter time frame as that will be more sensitive to current prices.

The only drawback here is that a moving average with a longer time span will be slow to signal a change in trend while a shorter time span moving average will give false signals as the prices will cut the average momentarily and resume its prior trend.

Hence a trader goes through this dilemma of reliability and sensitivity. There’s no magic solution to this problem. A trader has to find a balance between both his goals and choose a moving average accordingly.

Many a times people ask which is the best moving average that will achieve both their objectives but I doubt there will ever be such a moving average which will fit all stocks or indices. There are different cycles active on different stocks. Even in the same stock there will be cycles of different length working on different time.

So the best way to identify a time span for a moving averages is to activate several of them, just by clicking them on the chart, and then to select the one that best fits the data. Pick the one that acts more accurately as support or resistance for the stock or index that you are analyzing.

I do not have a specific parameter for moving averages instead whichever average gives me the best signal I use that and would recommend you all to do the same.

Please remember that neither a parameter (10, 20, 50 etc.) nor a specific type of moving average (simple or exponential) will always work perfectly on a stock or all stocks.

Even moving averages will be breached, so I suggest you all to maintain flexibility while choosing your moving averages.

Finally, I would say that choosing a time frame for a moving average is more of a trial and error rather than a perfect science.

Which time span moving average to do you use for your trading and investments? Share your views in the Club or share your comments here.

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5 Responses to "Moving Average Basics II"
ANIL SINGH
10 May, 2015
I follow: 7, 13, 20 days EMA for short term trend. 50, 75, 100 days SMA for medium term trend. And, 200, 300, 365 days SMA for long term trend. Regards!Like (1)
Ravindra Duvvuri
10 May, 2015
Your articles on Moving Average Basics I & II have been very useful, particularly for a person like me who is not familiar with technical analysis. I have a question: Since small cap stocks tend to undergo greater price fluctuations than large cap stocks, would it be prudent to consider a smaller time frame (say 1 month) for the moving average and a relatively longer time frame (say 6 month) for large caps? Like 
Thiru
10 May, 2015
Dear Apurva Sheth, Yes. MA is lagging indicator. But, it helps to do the entries based on "Trend Following" system. I have been following Two eMAs (20 & 48). The cross over gives a very good entry / exit points. Thanks & Regards THIRULike 
Arunangshu M Lahiri
09 May, 2015
Moving average was the first technical indicator in the sense that in early 19th century they didn't have the calculator even to work out any intricate statistical equation. In 21st century, even explaining that and in a sense encouraging novices to follow or use MA is downright criminal. Also, you should actually discourage people to bother about technical analysis if they are only positional traders. Does it matter when they buy or sell? On hindsight there would always be a better time, somewhere in future. Small investors should buy stocks and forget for next several years and if they are lucky (then will be called an investor with deep insight), will make a load of money. Or won't. It is a matter of luck. No technical analysis can help him cause there would always be a better time some years down the line. So to avoid this meaningless pursuit, ask them to trade intraday AFTER acquiring the appropriate technical knowledge. Admittedly, MA is great on hindsight. Both to spot trends as well as for support resistance but those are very nice to spot and talk about but utterly useless as decision making tools as to when to trade.Like 
Mohan Rathod
09 May, 2015
Can we try to find a correlation between % drop from top..(for trend reversal) & macd say 21e/55e....?Like 
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