Lesson 8

Utilizing Moving Averages as Technical Indicators for Trading Strategies

A technical indicator is a formula applied to stock data, such as price or trading volume. By applying the formula, we obtain a graph or chart that represents the results, which we can analyze alongside the stock chart.

Technical indicators are auxiliary tools used for tracking and analyzing price data in conjunction with chart analysis. While some traders make indicators their primary focus, they should be seen as support tools rather than primary trading tools.

One challenge with indicators is that they involve formulas, and different websites often have default settings within the indicators. Most technical analysts do not change the default settings of indicators, although these settings are intended for customization. This creates an advantage for those who understand how to utilize them effectively.

Contribution of Indicators

Alert: Indicators provide hints of potential changes before they become evident in the charts, signaling shifts in trends.
Confirmation: Indicators can confirm the existing trend.
Some indicators may offer predictive elements.

There are leading indicators, such as interest rates decreasing before the economy recovers, and lagging indicators, such as aircraft sales figures that reflect future trends. The beginning is always problematic, but as the trend continues, most indicators align accordingly. However, the end of a trend also poses challenges.

Leading Indicators

The advantage of a leading indicator is that it gives a hint before something becomes visible on the chart, indicating an upcoming change. The drawback is that sometimes, while we observe something in the chart area, it is challenging to implement what the indicator suggests. Typically, the indicator is applied slightly too early, and the stock continues to decline, posing a dilemma of whether to continue holding the position or not, which can be more problematic with options trading.

Confirming Indicators

Confirming indicators are easier to interpret as they describe something already present. However, they come with a delay. Additionally, they can confirm the continuation of a trend, which is beneficial for holding onto a specific stock.

Therefore, it is essential to work with both types of indicators, constructing a strategy based on comfortable prices. As the confirming indicators align and validate the leading indicators, the position can be increased while waiting.

There is no perfect indicator.

Changing the methodology while in a position is not recommended. The system can be examined outside of the position.

Moving Average

This line represents the average price of the stock over the past X trading days. Each day, the point that the moving average represents is the average price of the previous X days.

This calculation method is called the Simple Moving Average (SMA).

As we decrease the number of days, the line will closely follow the graph. As we increase the number of days, the line will have a greater deviation.

Methods for Working with Simple Moving Averages (SMA)

Basic Method

Sell when the stock crosses below the moving average and stay out as long as it remains below. Buy when the stock crosses above the moving average and stay in as long as it remains above. The crossing should pass the breakout test of 1%. A moving average reflects a lot of historical data, especially averages for 50 days and 100 days. However, this is the rationale behind the indicator. A downward crossing signifies that the stock is lower compared to its average price over the past 50 days, indicating a decline relative to the 50-day moving average. This decline can be interpreted as a trading signal. By examining the change relative to the average price, the signal becomes significant.

Which Moving Average to Use

If we take a 200-day moving average, breakouts will occur less frequently. The shorter the moving average, the higher the number of signals, but also the more noise in the market. The choice of resolution depends on the trader's style: an active trader may opt for a shorter moving average, while a long-term trader may choose a longer-term moving average.

An experienced trader suggests that the best moving average is 89 days. If there is no significant difference between 200 and 89, it is preferable to work with the 89-day moving average. The choice also depends on the type of stock – for volatile stocks, a longer-term moving average can help reduce noise, while for stable stocks, a shorter-term moving average may be more suitable.

Optimization can be performed by examining what suits the specific stock. For example, Intel may be better suited for a 50-day moving average. When conducting tests, begin with something that seems less or more suitable and then refine it until finding the moving average that appears to work best with the stock. There is an assumption that what worked in the past will work in the future. It is crucial to evaluate the strategy before purchasing the stock.

Thumb Rule: Determine the investment horizon:

Short-term: Moving averages of 3 to 10 trading days.
Medium-term: Moving averages in the range of 21 to 50 days.
Long-term: Moving averages in the range of 100 to 200 days.

It is common to choose numbers based on Fibonacci numbers: Short-term: 3, 5, 9. Medium-term: 21, 50. Long-term: 89.

The Dual Crossover Method

In the dual crossover method, we replace the stock with a shorter-term moving average. Instead of working with the stock and its moving average, we work with a shorter moving average and a longer one, such as 3 days and 10 days, 5/21. The selling signal occurs when the shorter moving average crosses below the longer one, and the buying signal occurs when the shorter moving average crosses above the longer one. This method neutralizes noise by replacing the stock with a short-term moving average of 3 or 5 days.

On StockCharts, the default is 50/200. Preferable options include 8, 21, 50, 89, or 100.