Many chart patterns are difficult to analysis and it’s close to impossible for a software program to draw out chart patterns because they are so subjective. But it’s very easy for a software developer to program averages because after all it’s just the average of certain data. I’ve even seen “black box” trading systems costing hundreds, if not thousands, of dollars that I could swear were only based on moving averages.
If you have two or three chartist sit down and look at a chart pattern you will often get two or three completely different viewpoints. One many see a trendline being broken; one many see an ascending triangle and one may not see much of anything going on. Moving averages on the other hand can’t be seen but one way.
The most common set of data used for its construction is a 10 day timeframe. However you can use anytime from you want, 10 days, 40 days, 100 days and so on. These averages are simple to construct and let’s use a 10 day average as an example. So one would take the last 10 days of closing prices and them together and divide by 10. On the 11 day you would add that day and drop off the first day. In other words it’s the last 10 days of trading used for the calculation.
There are of course more ways to use moving averages, like taking a short term average and a long term average and chart them using two separate lines. This system by its very nature is a trend following system whose sole purpose is to alert the chartist that the old trend has ended or that a new trend has started. Of course it is also a lagging rather than a leading indicator. It can only tell you what has happened in the past and does not project, on its own anyway, what the future may hold.
Shorter term averages will always stay closer to, or hug, the current price more than a longer term average such as a 30 or 40 day average will. While most people tend to use closing prices for their calculations it’s also possible to use other points like a midpoint value which is just the price that is halfway between the high and the low of the day’s range.
In another lesson we are going to talk about the various types of moving averages like the simple, weighed, smoother, as well as the use of multiple averages, like three moving averages used at one time. I will also go into more detail on how to trade using moving averages and how to combine them with other indicators.