Moving Average (2): Common Usages and Misconceptions
In my previous post I talked about the logical fallacy of using moving average. Basically it goes like this: if it rains, the ground gets wet. A wrong conclusion is made if one says if the ground is wet, it is raining or it must have rained. In using moving average, the fallacy is even worse as one often says “if the ground is wet, it is going to rain….”
In this post, we will take another look at some common usages of moving average:
Usage 1
Truth: In an uptrend, the moving average acts as a support.
Fallacy: If the price touches the moving average from above, it is a signal to buy since it has reached the support.
Fig. 1 IBM 6-month daily with 15-day moving average
But what really happened is the chart looks like this because the price is (or we should say emphatically it has been) going like that. Some explanation is needed here:
When the price has been going up, the moving average is below the price because moving average is a lagging indicator. This is seen between point A and just before point B. Then the price moves downward a little, but since the moving average is slower than the price, the moving average is not catching up with the price downward movement as fast. The result is that the price will get near the moving average or touching it (point B). Now since this is an uptrend, the price moves up again (usually for other economic reasons rather than because the price touches the moving average). Since the price is moving up again, the moving average resume the position of being below the price (between B and C).
In other words, the movement of the price causes the moving average line to look like what it does. It is not the touching of the price and the moving average that is causing the price to go up the second time.
The same thing can be said about the opposite, that is, in a down trend, the moving average acts as a resistance. Since it is just a mirror of the original statement, it will not be discussed here.
Usage 2
Truth: If the price has been moving up and is now moving down, the price will cross the moving average from above.
Fallacy: When the price crosses the moving average from above, a sell signal is generated.
I deliberately choose the same chart to illustrate the point. Typical a chart like this is usually shown, except that now point E is highlighted. The chart looks very convincing especially when one is looking at point E and notices that the price moves downward after the crossover.
Fig. 2 IBM 6-month daily with 15-day moving average
But what really happened is that there is a crossover because the price has been going up but then turning down. It is not the crossover that is causing the price to go downward. We have covered this in my previous post, so I won’t go into detail here. What I would like to discuss is the contradiction between the first and second usages.
The Contradiction
If you haven’t noticed it, please look at the two common usages again. The first usage says that if the price touches the moving average, the price will go up. The second usage says that when it touches the moving average, the price will go down. So which one is true? In other words, if you are using moving average to generate buy or sell signals, when the price touches the moving average, should you buy or sell?
The fact is neither is right. Or if you so desire, you can also say both is right because the price is going to eventually move in one direction or another; but the price movement is not determined by the fact of the touching or crossing over at all.
And if you are consciously aware of this contradiction, and you look at charts that suggest usage 1 or usage 2, you will notice the contradiction quite clearly, very often in the same chart. At point F, the price is touching the moving average, and later the price go down (so they say the moving average acts as a resistance). At point G the same thing happens again. At point H, however, the same touch happens, but the price goes up afterward (but now they position and say the touch/cross means the trend is changing direction). Whatever the direction the price might take, they can say they are right. The problem is how do you know which right is right?
Point I is worth examining too. It is touching the moving average from above, so it is similar to point A, B, C and D on the previous chart. According to usage 1, the moving average would act as support and so the price would move up. It did not. It moved down. Point J is the opposite. The price meets the resistance and so should move down. It did not. It moved up.
There are plenty of contradictions in charts like this. It is just that your mind is led to see only certain ones that an author happens to be writing about. Now that you can consciously look for this kind of things, please examine different charts honestly. You will notice that when an author is suggesting and illustrating a point, you can see a lot of contradictions happening in the same chart that he or she is using to illustrate his/her point!