Insights to Moving Averages

The concept of Moving Averages (MA) is very simple. But it is one of the most basic & important tool in Technical Analysis. So a good understanding of it is a definite plus.

I like to visualize it as a moving window of the data elements within. E.g. MA(12) is a window of the last 12 data elements and calculates the average of the numbers within. Simple Moving Average is the simply adding the 12 numbers & divide it by 12.

Exponential MA gives recent data higher weightage. Weightage of each earlier data are decreased according to an exponential function.

It is good to be aware which data the MA is plotting - often the Closing price but can be any of the High, Low, Open, Closed, Median (H+L)/2, Typical (H+L+C)/3 & Weight Closed (H+L+O+C)/4.

MA is often said to 'filter' or 'smooth' the curve. As seen visually above, MA 'smoothens' the minor variations of the data series.

This 'filter' action have the following characteristics:
1) The peak-to-peak values are decreased. Longer MA tend to reduce the Peak-to-peak values even more.
2) MA curves lags behind the data. Longer MA has more lag.
3) Curving MA indicates price acceleration/deceleration.

To illustrate point 3 above. Consider the (hypothetical) case of price increasing at a constant rate, the price graph as well as its MA (regardless of length) is a straight line function with a gradient.

If the price movement accelerates, then it bend upwards from the "reference" straight line. If price movement decelerates, it bend downwards. The shorter MA will bend more than the longer MA. Hence the shorter MA is more "sensitive" and the longer MA is more "sluggish".

So it is convenient to use a pair of MA, one with shorter length, to track the price movement; while the longer MA acts more like a "moving reference".

When the long & short MA inter-twined with each other and moves horizontally, there is no trend & market is moving sideways.

However when the price movements are trending, crossing of the MAs is generally used to signal a change in trend i.e. the shorter MA, being the more sensitive indicator, crossed the longer MA. Only time can reveal the change of trend, that's where lag properties of MA come into play. The price to pay is the price is always 'off peak' when the MA crossed (due to lag again).

Often when watching the formation of MA crossings (on H1 charts) , it may cross and then uncross. That's the situation when there isn't sufficient momentum of price movement to complete the crossing. Also often during such times, the 'gradients' of MAs are not very steep; indicating the price acceleration/deceleration is low.

There are times when a crossing is followed soon with a reversal crossing, giving a 'false' signal of trend reversal. Of course increasing both the length of short & long MA can avoid the situation. But how could we use a variable MA length to cope with all situations? In other words, the MA lengths chosen are suppose to be the 'best fit' for most situations, but can't be the 'one shoe size to fit all'.

MAs are the main tools in trend tracking, with various lengths on different time charts. Many other indicators are MA based in one form or another. If you study the Alligator indicator, you will notice it is based on 3 MAs with modified plotting of a few steps ahead.