Technical Analysis - Moving Averages

What is the most important indicator in technical analysis? Some of the traders may name you a row of various indicators which they learned from the bottom to the top and which they consider as the most useful and the most important in making a trading decision. The reality is that the most important indicator is the simplest one. The indicator without which technical analysis would not exist at all. The correct answer on the question about the most important indicator is - Moving Average.

Moving average is the basic and the simplest indicator in technical analysis. I would recommend to any beginner in technical analysis to start from moving average. Moving average is simply average value over specified period of time (price bars). There are a number of various moving averages, starting from the SMA (Simple Moving Average), EMA (Exponential Moving Average) and by finishing various complicated Weighted Moving averages. This technical indicator could be analyzed by itself but it also used as a component in most of the other indicators.

There are several thing that on the first view could be seen obvious, yet, that every trader should always remember about moving averages:

1. Moving averages are used to smooth movement fluctuation. It could be applied to price, volume, advance/decline data or any other data and technical indicator to smooth choppy movements and to see general direction of the movement of price, volume or any other indicator.

2. While moving average smoothes movement it brings factor of a delay (also known as a lag). The more you smothe the bigger lag is and the further in the time the moving average is shifted from the real movements.

When you go deeper in technical analysis there always will be a conflict. From one side you want to avoid choppy trading (frequent signals) which usually generates number of fake signals and from other side you want to keep the lag (delay in trading signals) as small as possible and to avoid late entering and exiting a trade. From one side you will have desire to increase bar period setting of a moving average or any other technical indicator to have more smooth trading and from other side you will be willing to have signals as close to the tops and bottoms as possible.

The truth is it is not as easy as it looks like. There is no golden rule what bar period setting should be used with moving averages or any other technical indicators. Before, selecting a setting for an indicator (in our case moving average) that would generate signals, a trader should learn how to recognize different market conditions. Because in different markets different setting would be recommended.

Volatility

In my previous post on August 30, 2009 ("Swing in Trading")  I have talked a lot about swing at the market open on August 28, 2009 by encouraging everybody to take a look at history to see what usually happens after such spikes in price during a side-way trading. I think, now, those who did not have chance to take a look at history understand what message I wanted to deliver. The massage was that this is important having access to historical charts. Ability to see the past gives you a tool to compare present price movement to the past, find similar patterns and act accordingly. I think the correction down we saw at the first half of this week (after my post) is the best witness of my words.

From my communications with other traders I know that many of them ignore analyzing history. The most popular way of trading is to take the most popular technical studies, apply the most popular setting and use the most popular trading strategies to generate signals. No offence, but personally I call it "gambling". With the same success you may go to casino.

The last person I communicated called himself an "experienced trader" and he was upset that a technical indicator does not work as it is told in the book… Again, no offence, but my answer is bs. This is great that people read books, go to the universities and receive education. However, real life, real job and real trading differ a little bit from what you read in a book and study in the university. Books and university gives you general knowledge and basic tools. However in real life, on real job in real trading you have to adjust what you learned, improve it and learn how to use it on practice. If you do not do it then you always going to be upset that a technical indicator does not work as it is told in the book and blame everything around in bad trading signals.

Most technical indicators were introduced 20-30 years ago, when nobody had access to intraday data and intraday charts. Most of the mentioned in the books setting for technical studies are for daily data and long-term trading. It is not a good idea to use the same indicators setting in intraday trading. It simply does not always work. When you look at 10-year chart you may ignore the market volatility because in 10-year frame you see market decline, market crash, recovery, up-trend, etc. Basically, you see different markets with different volatility in one time-frame. When you dig into intraday charts you cannot ignore volatility. On intraday levels, price trend acts differently in down-trend (high volatility), during the crashes (extremely high volatility), recoveries (middle volatility) and up-trends (low volatility). Respectfully, on intraday level a technical indicator setting should be adjusted in accordance to the market condition.

The simplest way of adjusting a technical indicator to the current market is

1. Find in the history periods with similar to the current market volatility and similar longer-term trend.

2. Find out what indicator setting would work best for you in those periods in history.

3. Try to apply the same indicator setting in current market.

In my understanding, the history is the strongest weapon in the arsenal of a trader and the most important component in technical analysis.

I think, I went out of my weekly posts topic. Coming back to it - see below the S&P 500 chart with the sentiment on technical studies I track. By the end of the week all technical indicators are bullish. The Nasdaq 100 and DJI technical analysis results look the same which is a good sign. There is still a room to the upper sensitive level.

The S&P 500 Chart with elements of technical analysis.