Moving average

"Moving averages don’t inform about trend; only about volatility"

• Volatility is lower when the stock is above a MA and vice versa
• This is more of a fundamental view to analysis, and technical adherents would probably disagree with the preceding sentiment.

The MA answers the question, "what if we took the high price of a stock each day over a period of time, and got the average of all of those highs?"

• so to get a 5Year MA, we take the average of the 5-day highs surrounding the date we are applying it to.

  • ex. to get MA of Year3, we would take the average of highs from Year1 to Year5. Carrying on, to get MA of Year4 we calculate the averages from Year2 to Year6. This is how we derive the trend line.

• Typical periods: 10, 20, 50, 100 and 200, but these really are arbitrary.

• Moving averages filter out the “noise” from random short-term price fluctuations.

• From a technical perspective, the MA is used to:

  1. identify trends
     • if price > MA, upward trend
     • if price < MA, downward trend
  2. identify support (floor) and resistance (ceiling) levels
     • More technical traders set stop losses at Moving Average-current price differentials (ie. they find the stop-loss point by subtracting the MA from the current price). When the current price crosses the MA, it indicates the occurrence of a sell-off or buy-in

• MAs with shorter time frames will react more sharply to price fluctuations

  • Therefore, the lower the MA period, the closer the MA will track the actual stock price.

• As a rule of thumb, the longer your horizon is, the longer the period of MA you will use.

  • This is because when you have a long-term view on a stock, you are more accepting of medium-term (~3-6 months) downturn periods.
    • If you were to choose the wrong period, you would notice that you would be inclined to sell on premature hints of a downturn. In other words, you wouldn't be as willing to "weather the storm"
      • This means that generally, volatility reduces the relevance of the MA. You pick a longer period to offset the amount that you "care" about volatility (remember: volatility only can exist in the context of a time-period, since a short-term trader sees a 5% daily swing as much more volatile a movement than an investor would view it).

• Longer MAs by nature have longer lag times, which impacts when we will consider something to be uptrend of downtrend.

  • This makes sense, because "trend" only makes sense in the context of a time period. A long-term investor is more tolerant of midterm "downtrends", but to him, they don't matter because he is looking overall, and asking "what is the stock generally doing"?

Crossover

• If you plot a short MA and a long MA together, you may be able to forecast an upcoming downward trend for the stock

  - Again, the MA periods you choose depend on your investment horizon. If you are looking at long-term, then you should use longer period MAs. Ultimately, all investors should want to "sell before a downtrend and buy before an uptrend". Which trends matter is the question that you have to answer. Is this stock a long-term play? very-long-term? medium-long-term? 
  

  

Exponential Moving Average (EMA)

• more for intra-day traders
• gives more weight to more recent prices
• Therefore, it reacts more sharply to price changes than a SMA

Moving Average Convergence-Divergence (MACD)

• shows relationship between 2 different moving averages
  • 12-period EMA minus 26-period EMA
• a 9-day EMA of the MACD (signal line) is plotted on graph
  • Crossover - if MACD crosses above the signal line, it is a buying signal. If it falls below, it is selling signal.
    • The speed of a crossover is a signal of how overbought/underbought a security is
• MACD helps investors understand whether the bullish or bearish movement in the price is strengthening or weakening.
• Since EMA is used, more importance placed on recent price data
• MACD has a positive value when 12-period MA is above 26-period MA.
  • spec: meaning the short term trend is surpassing the long-term trend
• MACD has a negative value when 12-period MA is below 26-period MA
  • spec: indicating the end of a long term t
• when price of stock moves away from MACD (divergence), it indicates an end to the current trend
• If MACD is dramatically higher than longer trend, it indicates the security is overbought

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Moving Average Timing Model

at the end of the month, see if index is still above the 200-day moving average. If yes, hold onto the stock. If it's below, sell it. at the end of each month, if the stock is below the 200-day moving average, sell it. Otherwise, hold onto it.