by Joe Duffy

A moving average is a lagging indicator because it naturally must have the price for a period before it can incorporate that period into the average.  A 20-day moving average lags prices, taking longer to make turns but flowing smoothly through some indecisive price wiggles that traders might want to avoid.

One simple application is that, if prices are above the moving average, you should be long; if prices are below the moving average, you should be short.  This strategy catches the early long move but doesn’t do as well in the choppy periods that usually occur.

Weighted and Exponential Moving Averages

Believing that recent price action is more important than old price action, some moving averages put more weight on the latest prices.  A 10-day weighted moving average, for example, multiplies the current period’s price by 10, the previous period’s price by 9, the price before that by 8 and so on down to the price 10 days ago being multiplied by 1.  The sum of those numbers is divided by 10 to get the weighted moving average.

The exponential moving average (EMA) uses a constant that depends on the length of the average.  In a 10-day EMA, the constant = 2/(10+1) or 2/11 = 0.1818.  Today’s EMA = yesterdays’ EMA + (constant * (price – yesterday’s EMA)).

Multiple Moving Averages

Rather than rely on one moving average, many trading systems use multiple moving averages, including some well-known combinations such as 4-9-18 and 5-10-20.  In a simple system involving two moving averages, the standard rules are relatively simple:

• When the shorter moving average crosses above the longer moving average, buy.
• When the shorter moving average crosses below the longer moving average, sell.

Using three moving averages gives you more flexibility such as multiple entries and exits.  For example, if the 5-day average crosses above the 20-day average, you might buy the first contract, then buy a second contract when the 5- and 20-day average cross above the 50-day.  In other words, if the three averages are stacked 5-day, 20-day and 50-day, top to bottom, you should be long.  If the 50-day is on top, then the 20-day and then the 5-day on the bottom, you should be short.

Some traders do exactly the opposite, depending on the market and conditions.  Because of the lag effect of moving averages, they reason that by the time the traditional signals shows up on a chart, it is time for the market to make its turn.  On a normal buy signal, they sell; on a normal sell signal, they buy.

Moving Average Convergence-Divergence (MACD)

MACD is a popular technical indicator that uses three exponential moving averages and is particularly good at picturing the strength or weakness of a trend.  The key MACD factors are not only crossovers of the moving averages, but the direction the averages are going, and that direction compared to the direction of prices.

You adjust the length of the moving averages to fit your trading needs.  For example, using 12 and 26 periods, you subtract the longer moving average from the shorter one to get one main line.  Then you calculate another exponential moving average, of the difference between the 12- and 26-period EMAs, which is known as the signal line and is usually shown as a lighter dashed line.  When you have these two lines, you use them like other moving average indicators, buying when the main line (the difference between the EMAs) crosses above the slower, smoothed signal line and selling when it drops below the signal line.

MACD can also be shown as a histogram, with each bar depicting the difference between the 12/26 line and the signal line.  A zero reading means no difference between the two lines.  Instead of waiting for the lines to cross, you can act on changes in the direction of the histogram as bars grow or shrink as the moving averages begin to converge or diverge.  Or you can wait until the histogram is above the zero line to buy or below the zero line to sell.  What is particularly useful is when prices indicate one thing – moving lower, for example, and MACD is doing the opposite – moving up.  That suggests MACD has detected underlying strength that is not evident on the chart yet, although it may take some time to show up in price action.