Saturday, January 23, 2010

Technical Analysis with Moving Averages - SMA & EMA.

Traders have seen the invention of hundreds of indicators. While some technical indicators are more popular (macd, Stochastics) than others, few have proved to be as objective, reliable and useful as the moving average (MA).
Moving averages help technical traders track the trends of stocks by smoothing out the day-to-day price fluctuations, or noise.By identifying trends, moving averages allow traders to make those trends work in their favor and increase the number of winning trades.
Every type of moving average is a mathematical result that is calculated by averaging a number of past data points. Once determined, the resulting average is then plotted onto a chart in order to allow traders to look at smoothed data rather than focusing on the day-to-day price fluctuations that are inherent in all financial markets.
The simplest form of a moving average, appropriately known as a simple moving average (SMA), is calculated by taking the arithmetic mean of a given set of values. For example, to calculate a basic 10-day moving average you would add up the closing prices from the past 10 days and then divide the result by 10.
These curving lines are common on the charts of technical traders, but how they are used can vary drastically. It is possible to add more than one moving average to any chart by adjusting the number of time periods used in the calculation. These curving lines may seem distracting or confusing at first, but you'll grow accustomed to them as time goes on.

The simple moving average is extremely popular among traders, but like all technical indicators, it does have its critics. Many individuals argue that the usefulness of the SMA is limited because each point in the data series is weighted the same, regardless of where it occurs in the sequence. Critics argue that the most recent data is more significant than the older data and should have a greater influence on the final result. In response to this criticism, traders started to give more weight to recent data, which has since led to the invention of various types of new averages, the most popular of which is the -
Exponential moving average (EMA):

The exponential moving average is a type of moving average that gives more weight to recent prices in an attempt to make it more responsive to new information. This type of moving average reacts faster to recent price changes than a simple moving average. The 12- and 26-day EMAs are the most popular short-term averages, and they are used to create indicators like the moving average convergence divergence (MACD). In general, the 50- and 200-day EMAs are used as signals of long-term trends. EMA responds more quickly to the changing prices. EMA has a higher value when the price is rising, and falls faster than the SMA when the price is declining. This responsiveness is the main reason why many traders prefer to use the EMA over the SMA. Below Tech.table will vouch for the efficiency of EMA (Note the change in colours alerting instantly).

Moving averages are a totally customizable indicator, which means that the user can freely choose whatever time frame they want when creating the average. The most common time periods used in moving averages are 5,10, 20, 30, 50, 100 and 200 days. Alternatively, fibonacci believers use 3, 5, 8, 13, 21, 34, 55, 89, 144, 233 days. The shorter the time span used to create the average, the more sensitive it will be to price changes. The longer the time span, the less sensitive, or more smoothed out, the average will be. There is no "right" time frame to use when setting up your moving averages. The best way to figure out which one works best for you is to experiment with a number of different time periods until you find one that fits your strategy.
Primary functions of a moving average are to identify trends and reversals, measure the strength of an stock's momentum and determine potential areas where an asset will find support or resistance.
Identifying trends is one of the key functions of moving averages, which are used by most traders who seek to "make the trend their friend". Moving averages are lagging indicators, which means that they do not predict new trends, but confirm trends once they have been established. This "lag" is somewhat mitigated by the arrival of EMA.
A stock is deemed to be in an uptrend when the price is above a moving average and the average is sloping upward. Conversely, a trader will use a price below a downward sloping average to confirm a downtrend. Many traders will only consider holding a long position in a stock when the price is trading above a moving average. This simple rule can help ensure that the trend works in the traders' favor.

To measure momentum, pay close attention to the time periods used in creating the average, as each time period can provide valuable insight into different types of momentum. In general, short-term momentum can be gauged by looking at moving averages that focus on time periods of 20 days or less(5,10,20).
Looking at moving averages that are created with a period of 20 to 100 days (25,50,100) is generally regarded as a good measure of medium-term momentum.
Finally, any moving average that uses 100 days or more (100,200) in the calculation can be used as a measure of long-term momentum.

One of the best methods to determine the strength and direction of a stock's momentum is to place three moving averages onto a chart and then pay close attention to how they stack up in relation to one another. The three moving averages that are generally used have varying time frames in an attempt to represent short-term, medium-term and long-term price movements. Strong upward momentum is seen when shorter-term averages are located above longer-term averages and the two averages are diverging. Conversely, when the shorter-term averages are located below the longer-term averages, the momentum is in the downward direction.
Support:
Another common use of moving averages is in determining potential price supports. It does not take much experience in dealing with moving averages to notice that the falling price of an asset will often stop and reverse direction at the same level as an important average. Many traders will anticipate a bounce off of major moving averages and will use other technical indicators as confirmation of the expected move.

Resistance:
Once the price of a stock falls below an influential level of support, it is not uncommon to see the average act as a strong barrier that prevents investors from pushing the price back above that average. As you can see from the chart below, this resistance is often used by traders as a sign to take profits or to close out any existing long positions.
Many short sellers will use these averages as entry points because the price often bounces off the resistance and continues its move lower. If you are an investor who is holding a long position in a stock that is trading below major moving averages, it may be in your best interest to watch these levels closely because they can greatly affect the value of your investments.
Stop-Losses:
The support and resistance characteristics of moving averages make them a great tool for managing risk. The ability of moving averages to identify strategic places to set stop-loss orders allows traders to cut off losing positions before they can grow any larger. Using moving averages to set stop-loss orders is key to any successful trading strategy.
Data Used in Calculation:
Most moving averages take the closing prices of a given asset and factor them into the calculation. It is my experience that it would be important to note that this does not always need to be the case. It is possible to calculate an "EMA"by using the close, high, low . When plotted on a chart or put in a "Tech.Table", these impact your analysis as well as your trading results in a very big way.
Finding an Appropriate Time Period:
Because most MAs represent the average of all the applicable daily prices, it should be noted that the time frame does not always need to be in days. Moving averages can also be calculated using minutes, hours, weeks, months, quarters, years etc. Why would a day trader care about how a 50-day moving average will affect the price over the upcoming weeks? On the other hand, a day trader would want to pay attention to a 5-Hour or 35 Hour average/ Ema to get an idea of the trading ranges. I have found the 5-hour High & Low Emas to be quite effective during intraday trading and 5 Day High & Low ema for positional trades.
Responsiveness to Price Action:
Traders who use moving averages in their trading will quickly admit that there is a battle between trying to make a moving average responsive to changes in trend while not allowing it to be so sensitive that it causes a trader to prematurely enter or exit a position.

Short-term moving averages can be useful in identifying changing trends before a large move occurs, but the downside is that this technique can also lead to being whipsawed in and out of a position because these averages respond very quickly to changing prices. It is highly recommended to look at other technical indicators such as Macd, Stochastics for confirmation of any move predicted by a moving average.
Beware of the Lag:
Because moving averages are a lagging indicator, transaction signals will always occur after the price has moved enough in one direction to cause the moving average to respond. EW STudy mitigates this "Lag". This again emphasises the point that no method should be used isolatedly to have consistent success in the markets. If you want to use only one method, then wait for the perfect set up and do your trades, though if the trades are a few but the success will be high.
Crossovers:
A crossover is the most basic type of signal and is favored among many traders because it removes all emotion. The most basic type of crossover is when the price of a stock moves from one side of a moving average and closes on the other. Price crossovers are used by traders to identify shifts in momentum and can be used as a basic entry or exit strategy. As you can see in the first chart, a cross below a moving average can signal the beginning of a downtrend and would likely be used by traders as a signal to close out any existing long positions. Conversely, a close above a moving average from below may suggest the beginning of a new uptrend.
The second type of crossover occurs when a short-term average crosses through a long-term average. This signal is used by traders to identify that momentum is shifting in one direction and that a strong move is likely approaching. A buy signal is generated when the short-term average crosses above the long-term average, while a sell signal is triggered by a short-term average crossing below a long-term average.
Moving Average Envelope:
Another strategy that incorporates the use of moving averages is known as an envelope. This strategy involves plotting two bands around a moving average, staggered by a specific percentage rate. Traders will watch these bands to see if they act as strong areas of support or resistance.
MA has also been used in the development of other indicators such as -
Moving Average Convergence Divergence (MACD)
One of the most popular technical indicators, the moving average convergence divergence (MACD) is used by traders to monitor the relationship between two moving averages. It is generally calculated by subtracting a 26-day exponential moving average from a 12-day EMA. When the MACD has a positive value, the short-term average is located above the long-term average. As mentioned earlier, this stacking order of the averages is an indication of upward momentum. A negative value occurs when the short-term average is below the long-term average - a sign that the current momentum is in the downward direction. Many traders will also watch for a move above or below the zero line because this signals the position where the two averages are equal (crossover strategy applies here). A move above zero would be used as a buy sign, while a cross below zero can be used as a sell signal.
Bollinger Band:
A Bollinger band technical indicator looks similar to the moving average envelope, but differs in how the outer bands are created. The bands of this indicator are generally placed two standard deviations away from a simple moving average. In general, a move toward the upper band can often suggest that the asset is becoming overbought, while a move close to the lower band can suggest the asset is becoming oversold. Since standard deviation is used as a statistical measure of volatility, this indicator adjusts itself to market conditions. The tightening of the bands is often used by traders as an early indication that overall volatility may be about to increase and that a trader may want to wait for a sharp price move.
Speed Kills, so usage of moving averages which smooths out the noise & Choppiness is your best bet to navigate your trading/ investments in this financial race field..Moving averages can be effective tools to identify and confirm trend, identify support and resistance levels, and develop trading systems. As with most tools of technical analysis, moving averages should not be used on their own(But tell that to my critic who uses just moving average chart to make perfect entry points), but in conjunction with other tools that complement them. Using moving averages to confirm other indicators and analysis can greatly enhance technical analysis.
This, more or less, covers all Technical analysis that are sufficient to make consistent money in the market - namely Trendlines, moving averages, Trend Analysis, macd, stochastics and the Tech.Table.
And that is "Getting Rich Slowly".

10 comments:

Ilango said...

As I have net problems, I am uploading this from an internet cafe.
I may not be able to update the "PreMarket View". Here is what may be done:
Book partially closer to the Friday's low or a bit lower than that.Based on the Asian mkts, if flat to positive, it may also bounce higher and then come down.This settlement should end closer to the lows. Plan your strategy accordingly.
As shown in one of the charts in this post, a reliable support will be seen only at the 200 day average.(4700-4600).

mok said...

ilango ji
very informative presentations from you, moving aaverage as well as the brew of coffee.
wish & hope your trading is not affected by the net problems.
have a good weekend.
with regards
Moh

Kishore said...

Ilango, I have been following your blog only for a week now, I am really amazed the wealth of information that keep sharing with everyone. Thanks so much for spreading the knowledge.

alpesh said...

hi
dear sir ,
plz check this link he is gives ew presntion abt nifty future :http://www.stockmaniacs.net/2010/01/how-to-predict-markets-using-elliot.html
he says that we are near to an intermediate top .
plz sir put some word abt this clearnce

The Analyst said...

hi ilango sir,
Please giude me for updating data for stocks to save the time..and also for hourly nifty and stocks..i take data from sharekhan..but for stocks its a cumbersome job..any other alternative..plase advice me..

satheesh said...

Once again thanks sir for your article

piyush sharda said...

ilango sir it was very nice article. Have a question that u or any other senior member of ur blog can answer. In your chart mentioning MAs of 5,10 and 20 (2nd chart frm top where u have also mentioned 'if u cannot digest the choppy moves follow the ma patiently')where u have probably used 5 and 10 ema crossover to generate buy and sell signals. Between 1st buy and sell there is a crossover which is ignored. Why? It would be a whipsaw but we cant know it in advance. Before the second sell also there is is a crossover which is ignored. I cant understand. Pls explain.

satheesh said...

Ilango sir, this blog of yours is a marvel. I really feel that though I have been into trading for the past three to three and a half years to admit, I have wasted my total time by not peeking into this blog for such a long time. Today the whole day right from morning 10.30 till 11.30pm except for a 2-3 hour break in between I was with your blog. So much of information that now my head is too full!!!! To admit the fact proudly - Today your blog has taught me soooo..oo.. many things which the market failed to teach me - rather I did not learn!!! All the mistakes which I made causing me to lose a few laks of rupees just opened glaringly before me and made fun of me. I had failed to see things which was blatantly laid right in front of the my eyes and behaved very crudely cursing my luck and the market. Ilango sir, hence forth with your blessings and guidance I hope not to repeat my mistakes and especially blame some XYZ for it!! Again I first wanted to send this message to your personal mail ID, but then i felt first i must be bold enough to admit my mistakes barefaced if i must not repeat them.

satheesh said...

once again thank you ilango sir.

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