Averages

Simple Moving Average (SMA)

The simple moving average (SMA) is quite easy to construct. A 5 day SMA takes the sum of the closing prices for the last 5 days and divides the total by 5. This basic approach is adequate on most occasions but may create a distortion when price does a large move up or down. The effect of this larger move will not be seen immediately because of the “5 day lag”

This “exaggerated” example shows how the data points for 4 days following a larger than normal price movement is not representative of actual price action.

This is obvious in the example but on lesser moves, the error is not at all obvious.

Exponential Moving Average (EMA)

The SMA has now been changed to an EMA (Exponential Moving Average). The calculation now uses a constant increase in placing greater value on the most recent data point.

It may be seen that the error has been reduced however the moving average is not representative of the price  action for some longer period of time.

Weighted Moving Average (WMA)

 The weighted moving average works much better in returning the price to normal somewhat sooner

Modified Moving Average (MMA)

The Modified Moving Average (MMA) mathematically applies greater weight on the most recent point in proportion to the deviation of price from normal.

Each of these calculation methodologies for a moving average have for and against arguments and it is often the case that personal preference is applicable.

Moving Average Combination

All four moving averages are 52 period (days) calculated on the closing price. The characteristics of each are obvious and an examination of each as a trading indicator reveals the short comings.

The 52 period is twice the 26 standard cycle period and in deciding what period to use, twice a detectable cycle length is appropriate. Common cycles are 9, 13, 18, 26, 36, 52, 72 and144. These may be either hours, days, weeks or months.

Moving averages will hold a trader in a trend when the market is trending well but when a market is trending well, almost anything works. The critical operations of a trading system occur during soft trends, consolidations or rapid fluctuations in volatility.

Common practice is to use an ADX line to define if a trend exists. The ADX line is a component of the Directional Movement Indicator found under the “price” section of the MA tools.

When the ADX line (the thicker line) is above 25 – 30 the market is described as trending and when it falls below 25, the trend is considered to be ending.

A 52 period WMA over a 10 period DMI

When the ADX line is above the horizontal centre band (inserted manually), the market is considered to be trending. If the blue line (+) is above the red, the market is considered a “buy” and if the red line (-) is on top, the market is considered a “sell”.

The same price action using trend lines and the higher low principle.