It is, in a sense, one of the most elemental human desires – to know what the future will bring. Or, at least, to have some idea.
Financial markets are not immune to this desire. Far from it. Since the establishment of organised exchanges for the buying and selling of financial assets, traders and investors have sought out ways to get an edge over their competitors by having a clearer idea than they do which way individual prices, and the market as a whole, are moving.
Some of this soothsaying was just plain silly. One example held that when the US dollar was at a certain rate against the Italian lira (now subsumed into the euro) this would automatically trigger assorted market movements.
Taking a well-founded view
For such an assertion, there was little evidence, and the whole notion sounds more like astrology than serious financial analysis.
Other times, the forecasters’ brilliance was easily explained when it emerged that they had been privy to inside information.
This is especially useful for those trading contracts-for-difference (CFDs). Whereas future price movements are an important feature of most trading and investment, CFD trading is centred entirely on taking a view on where prices are going, a view that needs to be based the proper use of reliable techniques.
Of these, moving average is one of the best-known. Simple enough in concept, it conceals some hidden complications, albeit ones that can be mastered.
As the name suggests, it represents the average price of any financial asset –shares, commodities, currencies, indices or bonds – over any time period, the period in question being of any duration, from a few minutes to many months or beyond, depending on the timeframe for the trading strategy. So, in very simple terms, a security that traded at $1 on Monday, $2 on Tuesday, $1 on Wednesday, $1.5 on Thursday, and closed the week at $2 on Friday had a moving average across those five days of $1.5.
Adding in some weight
What does it tell you about where the asset will open when trading re-opens on Monday? The short answer is, a lot more than if you had been given Friday’s $2 close, on its own, with no context.
That is, of course, a very simplified example. But it does explain the principle. For a trader, and there are many, who takes the view that “the trend is your friend”, that sort of moving average may well prompt a buying opportunity.
A declining moving average, in our example from $2 on Monday to $1 on Tuesday, to $0.5 on Wednesday, to $2 on Thursday and $1.5 on Friday, would have put such traders in a selling frame of mind.
This simple moving average has been criticised on the basis that it gives the same weight to Monday’s price as to Friday’s, which makes little sense, critics say, if the whole idea is to detect trends. Essentially, Monday’s price is acting as a drag on the trader’s ability to spot this trend.
Proponents say this gives a truer picture of the trend. The only caveat may be that, the more the weighting favours the most recent prices, the closer the average gets to that not-very-informative Friday closing price we looked at earlier.
Whichever average you chose, how – beyond just following the up or down trend – can you put it to good use in your trading strategy? One, slightly more sophisticated, technique is to try to spot trend reversals, turning points when the up or down trend is poised to change direction.
Suppose your chosen moving average is heading upwards. For the price to drop occasionally compared with the previous trading session may not matter, but were it to fall below the moving average, that could be taken as a reversal. The same is true, of course, of a falling price that breaks above the moving average.
Thus buy and sell signals are generated.
Looking out for crossovers
By definition, moving averages calculated over a shorter time period will signal a reversal many more times than one calculated over a longer timeframe.
By plotting the two averages together, you can see when they cross each other. When a short-term moving average breaks through the long-term moving average in a downward direction, that is often a sign of a pending reversal downwards. When the short-term moving average breaks through in an upward direction, that can be seen as a sign of an upward reversal.
All moving averages, simple or weighted, and however they are deployed in trading strategies are intended to screen out market “noise” and give a clearer picture of the real, rather than apparent, direction of the asset concerned. But be warned: there are times when moving averages can generate “noise” of their own, such as during periods of market volatility, when a short-term average, in particular, may start throwing off a flurry of misleading reversal signals that could prompt unwise trading decisions.
That said, the moving average, when used with due regard to what other, perhaps conflicting, market signals are saying, is a key piece of equipment in the trader’s toolkit.