We all know the trading clichés: buy low and sell high, take losses quickly and let profits run, fear and greed will ruin your trading, etc. It’s easy to look at a chart and recognize that if you had bought at the low and sold at the high, you would have made a bundle. Hindsight is wonderful. In our never-ending quest to find the perfect trading tool, we sometimes overlook simple ones.
A trend-following system is a viable approach to adhere to all of these principles — buying low, selling high and letting your profits run. The most common tool for trend following is the moving average. It’s where most beginners begin, and it’s where we can start to develop a better understanding of market analysis.
All technical trading is built on statistics, which is essentially nothing more than a combination of probability and arithmetic. An expected value formula can determine if a trading tool is beneficial:
Expected value = (profits on winning trade) * (probability of winning) —
(losses on losing trade) * (probability of losing)
If this results in a positive number, we have a winning system. But just because we have a winning system doesn’t mean it is the system we should be trading. We need to decide if it is a good one to use — and whether a better one can be generated.
A statistic (not to be confused with "statistics") is a number generated from a larger data set that represents that data set. An average is a statistic: data points are combined in some method to form a single piece of data. In a simple average — called the mean — all the data points are added together and their sum is divided by the number of points. This gives an effective equal weight to each point.
In a weighted average, certain points are given greater weight than others, and the sum of those is divided by the weight. An exponential average is merely a form of weighted average. The "moving" part of the name refers to the calculation adding new prices as they occur and dropping the oldest ones as they pass outside the window.
The moving average is a trend-following system that is easy to build and maintain. The simplest use is to buy when price crosses above the moving average and to sell when it crosses below. By definition, you will capture a portion of all trends, but you’ll also miss the beginning and suffer through a number of false positives when no trend ultimately develops.