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Moving averages are one tool to help you detect
a change in trend. They measure buying and selling pressures under the
assumption that no commodity can sustain an uptrend or downtrend
without consistent buying and selling pressure.
A moving average is an average of a number of
consecutive prices updated as new prices become available. The moving
average swallows temporary price aberrations but tells you when prices
begin moving consistently in one direction.
Trading with moving averages will never position you in the market at
precisely the right time. They are intended to help you take profits
from the middle of the trend and hold losses to a minimum.
The risks and the magnitude are intrinsic to
the speed of the moving averages. Professional traders lean toward the
faster averages and portfolio managers generally prefer slower
signaling moving average approaches.
Moving averages are a simple way to gauge the direction the tide is
flowing in a commodity market. They are not always right, but they
provide a wide variety of possible uses.
Lag prices
Moving averages lag prices because of
their makeup. You can make a moving average for any number of days you
choose, but remember that the more days you average, the more sluggish
the moving average becomes. Most commodity traders find a 3-day moving
average alone is too volatile. However, 4-day and 5-day moving
averages are common as short-term indicators.
To start a 4-day moving average, add the last four days' closing
prices and divide by four, The next day, drop off the oldest price,
add the new close, and divide by four again. The result is the new
moving average. Use the same system for any moving average you might
want to develop.
Moving averages give signals when different averages cross one an-
other. For example, in using 4-day, 9-day and 18-day moving averages,
a buy signal would be given when the 9-day average crosses the 18-day.
However, to avoid false signals, the 4-day average should be higher
than the 9-day.
Just the opposite is true for sell signals.
To sell, the 4-day average must be below the 9-day. The sell signal is
triggered when the 9-day average crosses the 18-day.
There are other conditions you might wish to place on your averages to
avoid false signals. One possible requirement is to make the 4-day
exceed the 9-day by a certain percentage before acting on the
appropriate buy or sell signal.
The caveat to moving averages is that although they work well in
trending markets, they may whipsaw you in a sideways, choppy market.
It helps to "tune" the moving averages to a particular market. A bit
of brainwork is necessary to use a moving average.
Some traders who use moving averages follow the slower moving average
signals to initiate a position but a faster moving average to exit the
trade, especially if substantial profits have been built up.
A linearly-weighted moving average also could
help eliminate false signals. A 4-day linearly-weighted moving average
multiplies the oldest price by four, the next oldest price by three,
etc., and divides the total by 10.
This weighted average is more sensitive to recent prices than a
standard average. The term, "linearly-weighted," comes from the fact
that each day's contribution diminishes by one digit.
The rules for trading a weighted moving
average are the same as using a combination of three moving averages.
The weighted average must be above or below the other moving averages,
or the signal is ignored.
A more sophisticated average is the exponential moving average, which
is weighted nonlinearly by using a specific smoothing constant derived
for each commodity to allocate the weight exponentially back over
prior trading days.
However, it requires high mathematics and a computer to determine each
optimum smoothing constant. |
