Examining the moving average tool
A moving average can objectively identify a trend in the market and that trend’s duration
A moving average is one of the most basic and frequently used building blocks of technical analysis. What is remarkable is how clearly and objectively it can identify a trend in the market, and how effectively it keeps performing, in spite of changing market dynamics.
Moving averages are what their name suggests - an average of data over a given period, such as 200 days, adjusted according to the start date and the end date. When the start date and end date moves, a moving average rolls, as newer data is added and older numbers are discarded. The longer a given time period, the less sensitive the average will be to movements in prices. Investors will look at moving averages of varying lengths depending on the time horizon of their investments.
For all its virtues, a moving average does have limitations. Notably, it is a lagging rather than a leading indicator. All technical analysis is ultimately backward-looking, as it typically relies on an analysis of past prices. In addition, technical disciplines maintain that once they are in motion, trends in the market tend to continue rather than reverse. “Even if a moving average provides a late signal, as long as a trend is durable, investors can continue to benefit after the signal,” says Roelof-Jan van den Akker, senior technical analyst at ING Commercial Banking in Amsterdam.
Another disadvantage is that, unsurprisingly, the indicator works best in markets which exhibit a discernible trend. In a trading or sideways range, whipsaws can buffet investors, as the moving average crosses back and forth over the price line. A 10-year view of the EuroStoxx 50 stockmarket index illustrates the point: during vigorous uptrends, for instance from 2003-2007, the average value of the market over the previous 200 days travels obediently below the ascending price. However, during sideways intervals such as 2009 and 2011, it zigzags or flattens out. “It may be difficult to spot at the time, but later you will recognise the sideways price moves,” Mr van den Akker says.
Wherever the moving average is tracking, remember this: the slope of the average is the critical clue to a changing trend. In 2006, the price of the EuroStoxx 50 dived beneath the moving average, while the average itself was still rising - hence no change in trend had yet occurred. After the plunge in 2008, though, the slope shifted down, to confirm a trend reversal. Ultimately, by 2009, the slope slowly flattened out as a new bull market was developing legs.
Just a few simple elements reveal complex scenarios. Technicians look at where a moving average is going both in respect to (a) the price line and (b) another moving average for a differing period. Situations where moving averages go below or above one another have earned colourful monikers. A death cross describes the pattern when a shorter-term average swoops bearishly below a longer term one. A golden cross signals the opposite, as the shorter average pokes back above the longer-term line. The dreaded death cross materialised in August 2011, as both 50-day and 200-day averages headed south, telegraphing that risks were increasing. By contrast, in 2004 and 2006, both averages, while rising, exhibited golden crossings.