Move the Markets

Misconceptions: Magic Moving Averages

Posted on March 28th, 2007
Written by Richard
Posted in: N/A (old archives)

I’m thinking about doing a series of posts where I address what I feel are the most common misconceptions among new (and even established) traders. I see these again and again when reading books and blogs. I feel kinda funny using that angle, since I’m not a wise (or filthy rich) trading guru.

But, I do have strong opinions, and a website… so… here’s the first article :-)

If I’ve talked with you recently about a topic, and then it shows up in this series, don’t think I’m singling you out! I’m only going to talk about things I’ve noticed all over the place. And, it’s just my opinion anyway… I’m not an investment advisor, or anything…

Misconception 1: Assuming a Moving Average Is Support

How many blog posts have you seen out there that matter-of-factly mention “and it had support from the 8MA” (or 5MA, or whatever)? A lot, that’s how many. But, when I go look at the charts, at least half the time all I see is a candle near a moving average. Since when is nearby equivalent to providing support? In fact, a lot of the posts that see fit to mention MA support are talking about failed trades, where the price fell right through their “support” level.

Math Doesn’t Hold Up a Stock. People Do.

First of all, think hard about what a moving average is; it’s just a calculation, usually only on the closing prices of the candles! It’s a lagging approximation of the price, which is purely an abstract concept. As such, it is incapable of providing support to anything. People support stocks (ok, and increasingly, machines too). The only reason moving averages work at all is because enough people are using them as guidelines.

What should that tell you? What it tells me, is that I don’t believe a moving average is support unless I see traders buying it up every time the price gets close to it. That’s a pattern that takes time to develop, and I think that usually means it’s a strategy more applicable to daily and weekly charts. Most stocks are just too fickle to trend along a single intraday moving average for long.

Here’s an example from the last two days of XOM. I might look for support near the 21EMA towards the end of the day on Tuesday. That touch around 2PM would represent the third bounce from the 21EMA area. But, I wouldn’t use the 21EMA for anything on Wednesday… the stock is totally disregarding the MA line…

People support stocks. That also tells me that there’s no reason to tie yourself down to any “magic” moving average period. If a stock seems to be following the 24MA, then use it, because apparently the people holding up the stock are, too. Only using the 20MA is like only drawing trendlines angled at 15 degrees…

That’s not to say that being near a given moving average is useless information. A stock that pops up and falls to its 5MA has slowed down until it’s able to touch its smoothed price from 2.5 candles ago. That tells you that it’s not running at top speed anymore. A stock that keeps tapping its 8MA is oscillating around its price from 4 candles ago. And so on… (the same logic goes for EMAs too, which also lag by 1/2 their period).

It’s A Support Area, Not a Support Point

A variation on the “magic” moving average mindset, is the assumption that a stock will stop dead and turn around right at the average price. The fact is, when you look at enough stock charts, it’s apparent that the price relationship to a moving average is usually rather sloppy even when it’s working. And yet, a lot of traders will place undue importance on a single point, like 15.73, if that’s what their average du jour happens to be right now. It’s no surprise these traders are often shaken out of their trades, even though they often turn out to be right about the eventual move.

A lot of people try to address this by making rules like “the candle has to close below the average before I’ll take action.” Maybe that’s an okay idea… I don’t personally go for it. I generally try to avoid putting special importance on the closing value of an intraday candle. After all, it’s not like trading stops between that candle and the next one. If you shifted the clock by five minutes, all of your 15min candles would close at different prices. Would all those candles suddenly mean something different? I would say no, aside from the influence of all the traders out there that do put importance on the candle shapes.

If the stock has been following the MA for a long time, you can try to gauge how sloppy the relationship is. Then, you could use that information to tune your entry, or at least make sure your stop is wide enough to keep you in the trade. More and more, though, I’m sticking to the same principle: people support stocks. So, I prefer to watch the T&S information, and try to identify apparent steady bids somewhere around the level I’m expecting support to materialize. Of course I can be fooled by the games they play, and am fooled all the time. It’s not an easy game, no matter how you try to play it!

Consider It a Signal Processing Problem

Maybe at some point I’ll do a post about all the interesting ideas floating around from the signal processing realm. Essentially, they describe methods to decompose stock movement into:

• a trend component, which is the overal direction of a stock, and is usually assumed to be either a straight line, or a simple curve
• a noise component, which is semi-random oscillation

From this decomposition, they can make observations about the signal-to-noise ratio of the stock, and attempt to jump onto an uptrend while at the bottom of the noise range. It reminds me that, because of the way many trading signals are built, a lot of us get in at the top of local noise, which puts us immediately into the red until the trend we’re on pulls us out of it (if we’re lucky). Maybe there are better ways?

It’s neat stuff, but obviously not foolproof. If it were, they’d all be filthy rich. But, reading about it really clarified the reality about indicators like moving averages for me.

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© 2010 Richard Todd. I am not a financial advisor, and nothing on the site should be considered investment advice or actionable recommendations. I'm just an individual, saying what I think, and sharing my experiences.