Technical Analysis -- Moving Averages: Truth Or Consequences

For anyone day trading or night trading, the need to recognize a trend, consolidation, or a break out is critical to being successful. As such, these investors spend a great deal of money purchasing expensive financial widgets (indicators) designed to give them signals when to buy and sell. The grand daddy of all indictors is the moving average. But is this indicator worth its salt, or is it just outmoded.

First off, what is a moving average. To understand moving averages, the first thing to understand is that technical analysis widgets are based upon the same 3 elements: the price (of the stock, or in the case of futures and options, the contract), volume (number of shares or contracts being traded), and time ( as it moves along during the course of the day). There are basically two kinds of indictors, lagging and forecasting. Moving averages by their very nature, fall into the lagging group.

A lagging indicator summarizes past price movements rather than forecasting future ones. You will quickly see why moving averages are lagging indicators. Moving averages are calculated by adding up the price of the last so many time periods, and then dividing by that time period number. Say you want to see a 10 minute moving average. Add the final price that occurs in each of the 10 minutes (the price at the 59th second of each minute) and then divide by 10. That gives you a moving average for 10 minutes. You can see why it is considered lagging...in order to see the current minute's value, the entire minute has to complete before the calculation is made. These are the consequences of moving averages. The price may have already moved on by the time the current value is available.

But what is the truth? Since the moving average calculation is based upon what has already occured, it is true. It happened. It is not fiction and it is not forecast. The consequences of forecasting indicators instead of lagging indictors is that they are just that, a forecast. That forecast may or may not ever happen. It is not necessarily even true that there is a 50-50 chance of happening, let alone more than 50/50. So having the truth on the chart is essential to being successful. While a technical analysis chart may also have forecasting indictors, it must show the truth as well.

There are expensive widgets that are now available that call themselves "non-lagging" moving averages. That is an attempt to marry truth and consequences. Are these recommended? No, in fact you should run away from them as fast as you can. Why? Because the market does not use these "non-lagging" indicators. The market only knows and only understands a specific set of moving averages. Moving averages are used by the market for support (a floor below which the price can't seem to go) and resistance (the ceiling above which the price can't seem to go). If you use non-lagging moving averages, the market does not know anything about those. Moving averages have a number of important uses, one of which is to put truth on your chart. Replace those with artificial moving averages and the truth will be lost.

The key to successful trading is to have both truth and potential consequences on your charts. So don't listen to those who pooh pooh moving averages as strictly passee since they are lagging.