Moving Average (1): Knowing It and Its Fallacies
I will start my first blog on moving average, which I think it is a much abused and misused indicator. If you have read anything on moving average, you must have noticed that most authors tell you that it is a lagging indicator, i.e. it only tells you what has happened in the past. Yet most author will then describe, usually in the same article, how moving average can be use to predict future!
There are a few things that one must clearly be aware of when using moving averages:
Average by itself does not tell much.
Let’s say the closing prices of a particular stock for the past 5 days are 5.1, 5.2, 5.3, 5.4, and 5.5 (increasing in price), and another stock has the price of 5.5, 5.4, 5.3, 5.2, 5.1 (decreasing), yet another stock with 5.3, 5.3, 5.3, 5.3, 5.3 (unchanged). All of them would have the same moving average of 5.3. The average by itself does not tell you anything about the market condition.
Moving Average uses old/past data.
When one uses moving average, he is actually observing the change of the averages (usually graphically). If you are using a 10-day moving average and you are looking at how the averages increase or decrease in the past 10 days, you are actually looking at 20 days of old data.
Some people use 20-day and 50-day moving averages, which means effectively you are looking at data about 70 or more days ago. Frankly, in this fast-moving internet age, I don’t know if the price 70 days ago is going to have that much effect on current price. For example, in today’s news, Toyota is subpoenaed by a U.S. federal grand jury for documents related to problems in its vehicles. That fact and the eventual outcome of it are going to affect the stock price of Toyota more than its price 70 days ago.
Moving Average is a lagging indicator and must be used as such
There is a common logical fallacy involved when moving average is used. In logic the fallacy is called the fallacy of affirming the consequence, and it goes like this: if it rains, the ground is wet; so if the ground is wet, it must have rained. But that is not always true. It can be true but it cannot be argued from logic that if the ground is wet, it must have rained because there are other reasons why the ground can be wet. Another way of saying it is if A then B does NOT necessarily mean if B then A. Unfortunately that mistake is almost always committed when one uses moving average.
Example 1
fact: When the security is in an uptrend, the moving average is going upward, and the price is above the moving average.
fallacy: When the moving average is going upward, and the price is above the moving average, the security will go up.
The factual statement is correct simply because of the definition of moving average and so the moving average is lagging. But a common use of moving average is fallacy part. The price has been up in order for the condition to be true. The price can indeed increase further for thousands of reasons, but it can also decrease for thousands of other reasons, but it just cannot be concluded that since the moving average is below the price, the price is going to go up.
Example 2
fact: If the price has been in an uptrend and then the trend reverses, the price will cross the moving average.
fallacy: If the price has been in an uptrend then the price crossovers the moving average, the trend is reversing.
Again, the fact part is true by the definition of moving average so moving average is lagging. Because the closing price is going to go from above the moving average to below it, at one point it is going to cross over it (see the chart below).
But notice how another common use of moving average is based on the same logical fallacy: it is so frequently said that if the price line crosses the moving average line and become higher (or lower) than the moving average, it generates a buy (or sell) signal.
Usually a chart like shown above is presented (in this case, QQQQ from Feb. to Jul 2010, with its 25-day moving average) and the chart looks very convincing. Your eyes are led to see that the price line crossed the moving average and then the price seems to go down indeed; but what happened was actually the opposite! The price first stopped increasing, then decreased and so it eventually crossed the moving average. That is how the moving average line is constructed! The price drop was causing the crossover, not the crossover causing the price drop.
If you are not used to thinking this way, I know it may sound unconvincing, but think about it for a moment or two. In my future posts I will show more charts to illustrate this point.
PS: Your input and feedback would be greatly appreciated whether you agree with me or not.