Moving Average (3): A Reasonable Usage
If you have read any of my posts on moving average, you know I dislike or discourage the use of moving average in making decisions. In this post I will discuss a use of moving average which I consider reasonable because it is using moving average (a chart of past data) to get a feel of what has happened in the past. This is certain more reasonable that using the past to blindly predict future.
The reason I dislike most of the usages of moving average is simply because the logic involved is often reversed: if things were going nicely (like if the price had been going up/down steadily with normal fluctuations), then the moving average chart would look nice too. However, we are often led to believe that when the charts look good, prices are going to be good and predictable as well. That is the logical fallacy that I described in my previous posts.
However, there is some use of longer-term moving average that might make some sense if properly used. The one I am thinking of is the use of 2 moving averages and their crossover.
Crossover of Two Moving Average
A caution must be made first. With the contradiction and fallacy mentioned in my other posts, I am not saying that all of the sudden the longer-term moving averages become so useful in predicting future. My view is that moving averages are never good in predicting future as it is just a graphical view of what has happened in the past.
But that is exactly how we are going to cautiously use it: to see the past. Moving averages are averages of past data, so they do a good job in smoothing out small variations / fluctuation of prices in the past. If we use them that way, we are using precisely how it is meant to be used.
Because of its smoothing feature, when you look at a 50-day moving averages, for example, and it is changing direction, it is often true that the longer-term prices (if you consider 50 days to be longer term, of course) have reached a certain low or high and is now changing direction. If this is confirmed by a shorter-term moving average (e.g. 10-day moving average), it means prices have changed direction in the longer-term and have now been confirmed by the shorter-term prices.
But that alone should not trigger a buy or sell signal. It is just a signal for you to start paying attention. The current economic condition, recent news about the company or the funds, the global economy or political situation and many other events will affect the price. The crossover tells you that you can at least start watching the particular security and make considerations along with other factors.
And that is why I always tell others that you need to know exactly what an indicator is telling you. If moving average chart is a chart telling you something about the past, sure it is able to tell you something about past. This might sound redundant but I can’t overemphasize the important of this principle: to know exactly what a particular indicator is, how it is constructed / calculated and what it means. Sometimes you need some math to be able to understand it, but you certainly cannot just trust somebody else’s writing. I believe many authors have different motivations / agenda when they write.
Now let’s take a look at a chart with 2 moving averages (DIA, 1 year, 15- and 30-day moving averages). If you look at points A and B, you can see that at or near those points, the prices have indeed reached some high or lows in the past. To be more precise, it has actually past its low or high, but moving average is a lagging indicator, and we all know that.
You should also pay attention to points C and D where the crossover “signals” failed. Again, ultimately it is the fundamental issue or news that drive prices.
So here it is. At least I am presenting some good use of moving averages. The principle is worth mentioning again: if you use an indicator for what it really is, then it is ok. Don’t use an indicator that is specifically designed to plot past data (as moving average does) to predict future.
DIA 1 year Daily
In the next post, we will try to predict future with moving averages! You are all invited.