Monday, April 30, 2012

What Moving Averages Tell Us

MetaStock SPRS Series - Week 66 - TechniTrader® Stock Discussion for MetaStock Users - What Moving Averages Tell Us - April 30, 2012
By: Martha Stokes C.M.T.

Moving Averages were the first stock indicator ever employed to analyze stocks. Yet even today most traders don’t use moving averages or understand moving averages to the extent that they should.

Statistical averages are used everywhere, not just in the stock market. There are many types of moving averages. Averages provide a smoothing of the data to get a better view of what is going on.

Some moving averages drop off the oldest data as new data is added. This is the standard approach to most formulas for stock indicators. There are also cumulative averages which accumulate data as the average moves forward.

Chart 1

The Mode considers the distribution of price variances rather than the size of the price changes. The formula considers the location of the greatest concentration of similar prices as the typical value.

The Mode method requires a rather substantial amount of data to function properly, so a 5-day mode would not be effective. Mode discounts extremes in data and helps find the center, or commonly occurring value.

The Median defines the true center of data even when you have an incomplete set of data. The Median is not skewed by extreme variations but it is not readily adaptable to computational methods for use in formulations. The Median would be the accurate center or price of 5 days of variations, for example.

The Mean has several ways it can be calculated:

Arithmetic, Geometric, and Harmonic are the most common.

For most stock indicator formulas, the moving average uses the Arithmetic Mean and so everything is skewed or impacted whenever there is a significant price variation or price spike. Many stock indicators that use Price and Time use a simple moving average using the Arithmetic Mean calculations. The simple moving average also places the least importance on the most current price. Therefore, these indicators will ALWAYS lag regardless of the period settings. Tightening the moving average will only create a highly reactive indicator rather than a leading indicator for price.

So what CAN moving averages tell us? In the chart below, MEOH, what the moving averages are telling us clearly is that price has shifted sideways. The stock is no longer trending up. This is very useful information because it helps traders shift their trading style and their style strategies to adjust to the changing trading conditions for this stock. Moving averages are an easy what to identify that a price has shifted sideways. This alerts traders to look further to understand WHY the shift to a sideways pattern has occurred.

Chart 2

Why has this stock shifted sideways?

It tested its all-time high and backed off which is common. Note the TTQA is very strong during this sideways action AND also that the formation is a triangle.

Chart 3

Triangles are a compression pattern. All compression patterns end with a sudden breakout move, either up or down, depending upon the preceding price action, VOLUME, and accumulation/distribution patterns. A triangle is a dual compression pattern where the highs are dropping and the lows are rising in a symmetrical pattern. This creates energy. The tighter the price, the more energy that builds.

The breakout usually occurs prior to the conclusion of the triangle where the highs and lows would come completely together.

Triangles are usually, not always, continuation patterns for a trend.

Trade wisely,

Martha Stokes, C.M.T.
Member of Market Technicians Association
Master Rated Technical Analyst: Decisions Unlimited, Inc.
Instructor and Developer of TechniTrader® Stock Market Courses
MetaStock Partner

©2012 Decisions Unlimited, Inc.

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