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4-23-99 Page

Technical Analysis - Moving Averages

1. When asked, "How many people attend your seminars?" I'll respond, "about 25, on average ." While not precise, it satisfies. The idea of an "average" is very important to communic ate ideas.
2. We often use averages to convey important information, especially when the numbers vary. It is easier to put data (numbers) in buckets (averages) than to deal with all the noise (variation).
3. Averages play an important role in the technical analysis of stock prices. On a price chart, averages smooth the data to give us a better view of the underlying trend. Two caveats about using averages:
   • When asked, "How many children do you have?", it would raise a few eyebrows if we respond with an average. There are occasions where an average does not help.
   • "My heads in the oven and my feet are in the freezer, but on average, I'm pretty comfortable." The average by itself doesn't tell the whole story. We need a measure of the spread of the data, how much variation is represented in the sample.
4. In the chart below, we show closing prices for NSPK from December 29th to April 15th. The data for the chart follows. Question: Is there a trend? Which direction? Our most important goal is to identify market trends and then to know when a trend is making a change.

   
   
   

5. We might say there are several trends, but lets see what a moving average can do for us. The first 13 data points in the table are shown here with calculations for a 5-day moving average. The first average, $11.08, equals the sum of the five data points all divided by 5. The second average drops the first data point and includes the 6th, and so on. Each five-point average smoothes the data, with the result plotted on the price chart below.

   
   
   

   
   
   

6. Notice the darker moving average line does not start until the fifth data point. This is a smoother plot, with trends a little more obvious.
7. Now lets extend the concept to more data points in each average. The following is the result for a 15 point MA:

   
   
   

   
   
   

8. Why are we doing this? What value does a moving average provide? Look carefully at the chart above where the price chart crosses the moving average. Technical analysts compare the MA to the price line and note the relationship between the two. For instance, in the chart above, a buy signal occurs when the price rises above its moving average. When the two lines cross, a change in the trend is the message. Notice the clear signal on 4/6/99. Similarly, a sell signal occurs when the price crosses down through the moving average.
9. Very simply, a trend is considered moving up when the moving average is below the price chart. This reverses when the price line moves below the moving average.
10. The moving average is a "lagging" indicator. It tells us a change has occurred, after the fact. This is not a system that will get us out exactly at the top nor get us in at the very bottom. It will help us understand the prevailing trend and help us to buy not long after the bottom and to sell not long after the top.
11. We have shown two moving average examples. What is the best number of points to include? Here is an area where paper-trading with historical data can help us focus on the right moving average for the particular trading strategy we use. With hindsight, we can find the moving average that would have returned the greatest profit.
12. The best moving average depends on our time frame. If we are concerned very long market cycles, a longer moving average is more appropriate. For instance:
    • Long-term (6 months to several years ): 200 day MA
    • Intermediate-term (1 to 6 months): 50 day MA
    • Short-term (less than a month): 15 or 20 day MA
13. These are only guidelines. If a stock rolls every two months, a good MA would be 30 days. A general rule of thumb would have us use a moving average of half the cycle length. A roller that cycles in 30 days would use a 15 day MA, etc.
14. Before we close, take a look at the price chart for the Dow Jones Industrial Average over the last year. Notice how the correction that took place was signaled by the shorter 50 day M A in June, but the 200 day MA responded in August. Shorter period MA's are more sensitive, but can also provide false signals more often.

    
    
    

15. Summary:
    • The moving average (MA) is one market indicator that can help us execute market strategies.
    • Although it can signal changes in trends, it is a lagging indicator. We will always buy and sell late.
    • Other indicators we will consider in this series can serve as leading indicators, helping us anticipate changes in the trends.
    • When used together, all of the indicators will push a few more chips to our side of the table, increasing our likelihood of success. Risk, as discussed previously, is not left to fate or a roll of the dice. Risk can be managed, which is the intent of the Pro-fundity page.
16. Study Schedule:

    April 30 - Trading bands, Bollinger Bands, Dow Theory

    May 7 - Oscillators [Leading indicators]

    May 14 - Wilder's relative strength index (RSI) Divergences, Convergences

    May 21 - Stochastics, MACD, On Balance Volume (OBV)

    May 28 - TC-2000 pr oprietary indicators (BOP, MS, TSV)

Understanding :

is our intent to help our readers understand market strategies well enoughto make informed decisions and understand the risks.

We provide TC2000 tutorials to members upon

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