From the November 01, 2008 issue of Futures Magazine • Subscribe!

Using moving averages to do better than average

An average is designed to give the user a fair representation of the scope or quality of a larger group of numbers. A college graduate will be interested in the average starting salary of a job in his or her particular industry. A general manager in baseball will be interested in the batting average of a particular player. In reality, the college graduate may do much better or worse than his peers. The same is true for a general manager who generally underpays for young players on the rise and overpays for stars past their prime.

When it comes to financial markets, moving averages are used to provide a fair representation of recent price action and help traders anticipate what may come. However, they are still best used as a guide. There are many pieces to the puzzle when it comes to analyzing a price chart, and it is important to understand what moving averages mean and how they are used in gauging market activity when you consider which piece of the puzzle they represent.

Here, we’ll look at some common applications of moving averages and advance to how they work with other techniques to provide a clearer overall picture of market action.

USING AVERAGES TOGETHER

Among moving averages, all traders have their favorites. However, in terms of popularity, it’s hard to argue the widespread use of the 50- and 200-day moving averages.

“Before the fall” (above) shows a chart of action in the Dow Jones Industrial Average. During a good bull move, price action will generally pause or pullback to the 50-day moving average. It may do this several times in the course of the move. However, there comes a point where the 50-day is violated and putting other technical factors aside, this is an important clue to a change in trend. When this happens, the correction is larger than a pause in the uptrend.

On the other hand, we don’t know what may happen in the larger picture. After extended bull or bear markets, traders and technicians alike are looking to see if the 50-day will cross the 200-day. When this cross materializes, it usually means a market is confirming a larger degree trend change. Many times, this crossover will occur close to an important universal time window.

In the recent case of the Dow, this cross happened at the Fibonacci-significant 55 days off the top. This crossover doesn’t guarantee a larger degree change, but it does increase the prospects of one. Because it is not a guarantee, though, we must consider these moving average crossovers a guide. However, when they materialize at important time windows, probabilities of a turn increase.

After the low is established and price action moves to the technical-bounce phase off the low, the moving average becomes a target for the termination of a bounce. Many times, the moving average will line up near an important Fibonacci retracement level. In this case, the 50-day moving average is retested in March when it is close to the 38% retracement. It is important for traders to recognize that these points on the chart act as magnets. If price action is going to fail, the higher probability outcome is the failure will materialize at the 50-day or even the 200-day.

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