Over
the past decades, attempts have been made by traders and researchers aiming to
find a reliable method to predict next action of the securities. As a result we
have a variety of different fundamental and technical analysis methods and many
theories today that really work. For the first pace I want to discuss technical
analysis which is very popular these days.
Technical analysis is a
common method to evaluating securities and determining the next direction of the price through
using chart patterns and mathematical indicators or a combination of both. Many
believe that it is the most reliable way to find out how supply and demand is
going to be changed and what is the latest decision made by market
participants. As a matter of fact a large portion of market traders prefer to
use technical indicators to confirm suggested chart patterns or trading
opportunities.
Sometimes indicators act like they are
completely wrong in predicting or confirming the direction of the market. Is it
because they are absolutely useless or maybe you read them in a wrong way? The
answer is, sometimes the market environment is not suitable for a particular
indicator. That means you can't use a trending indicator in a range market and
vice versa.
Also sometimes different technical indicators
signals conflict and it is not easy to pick the right interpretation between
the possibilities that came out of each indicator. This is because of the
nature of each indicator and this kind of outcome often means "a wrong
setup". You must make sure that no indicator can always show you the right
trading signal. So I think it is a must, for traders to understand the nature
of the indicators and effectively avoid their noises.
However, I am going to introduce the most
common technical indicators and the tips around them.
Moving Averages
Simple Moving Average (SMA)
A Moving
average simply measure the average price or exchange rate of a security over a
specific
time frame.
For example, 5 day Simple Moving Average is the sum of last 5 days closing/opening price
divided by the number of time periods (5).
Day
|
1
|
2
|
3
|
4
|
5
|
Price
|
6
|
4
|
6
|
8
|
10
|
5 Day SMA
|
-
|
-
|
-
|
-
|
6.8
|
Exponential Moving
Average (EMA)
While
the simple moving average is a lagging indicator, we may find a way to reduce
the lag. To do this, it is better to use another kind of Moving average which
called Exponential Moving Averages. Exponential moving averages reduce the lag
by applying more weight to most recent prices relative to older prices or In
other words it is a weighted simple moving average putting more weight on the
today's closing price.
The weighting applied to the most recent price fully depends
on the period of the moving average. That means if you apply a shorter period
to exponential moving average then you actually placed more weight to the most
recent price. So we should take this into consideration that an exponential
moving average (EMA) react much quicker to most recent price movements.
Also
remember, a 10 day EMA is in fact more than 10 day moving average as it could
include data from the entire life of a security. It can smooth the price
changes and at the same time react to price changes very quickly .Therefore
Exponential Moving Average often identified as the best kind of moving averages
among short term traders in Forex and Futures market day traders.
Today
most of charting applications calculate the Exponential Moving Average
automatically, so you don't actually need to get involved in confusing
mathematical formulas to calculate the EMA price. If you are still curious
about the way an EMA calculate, so in brief:
The
EMA Takes today's price and multiple it by specific percentage as a weighting
factor and then add the result to yesterday's EMA multiplied by 1-EMA
multiplied weighting percentage. The weighted percentages will calculated as
below:
Example: The EMA% for 5 days is 2/ (5 days +1) = 33.3%
Weighted Moving
Average (WMA)
Weighted
Moving Average is a kind of moving average that put more weight on most recent
data and less weight on older data. A weighted moving average is calculated by
multiplying each of the previous day's data by a weight. To calculate this kind
of moving average we have to put a weight of 1 to oldest data and then 2 for
next data and so on up to the current price. The applying weight is based on
the sum of the number of days in the moving average.
To calculate 5 day
WMA calculates the weight of the first day as below:
Divide
the number of each day by sum of the number of days (15) and multiply it by the
value of the security (Price). For the last step, you should add all 5 weighted
values together (sum).
The sum of the number
of days = 1 + 2 + 3 + 4 + 5 = 15
5
day weighted moving average (WMA) = 2.33 + 4 + 8 + 12 + 16.66 = 43
Day
|
1
|
2
|
3
|
4
|
5
|
|
Value of the security
|
35
|
30
|
40
|
45
|
50
|
|
Weighting factor
|
||||||
1/15
|
2/15
|
3/15
|
4/15
|
5/15
|
||
Weighted value
|
||||||
2.33
|
4
|
8
|
12
|
16.66
|
||
Practical Ways to Use Moving Averages:
Moving averages can be used as a tool to:
Identifying a trend
Identifying Support
& Resistance levels Identifying price breakouts
Measuring price momentum
Moving Average can be
used easily as a tool to identify an uptrend market when
-
The
moving average is rising
-
The
price line tend to be above the moving average
- A shorter moving
average crossed the longer moving average
Normally,
a longer term map of the trend gives us much reliable perspective for the fact
of what's going on with the market. In order to identify a trend you should
take a look at a longer term chart like Weekly or Daily to see what the major
direction of the price is. Remember that this is very important to make sure
you are not on the wrong side of the market because a large number of big
losers easily had too many trades against the major trend. To identify the
longer term trend you can draw 200 SMA and 144 EMA onto the chart. Simply when
the 144 EMA is above the 200 SMA and at the same time the price is above the
200 SMA while both moving averages are diverging.
Now,
we have the big picture of the market and we at least know that a LONG trade is
not as risky as a SHORT trade. However, a short term trader needs a short term
signal to enter the market. A short term LONG signal would identify when:
-
The
144 EMA crossed the 200 SMA on 4H chart ( you can use 1H chart but it has more
noises than a 4H chart )
-
The
price must be above the 200 SMA
- The MAs is diverging
-
MAs and especially the 144 EMA must be in a
rising form (this is a visual experience and normally helps to avoid noises)
How to identify range
market by Moving Average:
As I
already explained, a trend market would be confirmed when two moving averages
diverge from each other. In other word, when a market is in an uptrend the
shorter moving average tends to diverge quickly from the longer moving average
and this makes the distance between two moving averages looks wider. This
phenomenon indicates that the momentum of the price is rising.
Otherwise,
when two moving averages are converging after they diverged once earlier (Where
we took the LONG trade), the price tends to pull back and this means the
momentum of the market is slowing, so the LONG trade is about to be invalid and
we must exit the market.
Furthermore,
two moving averages are on their way to cross over again but this time shorter
moving average cross the longer moving average in opposite direction
(Downward). The downward cross over of two moving averages gives us very
valuable information in which
the
momentum has slowed into levels that the price can not rely on it anymore. A
very weak momentum would means that the market is going to be lazy
(Consolidation) so we must avoid this situation and wait till a new clear
signal tell us what to do next.
Final Word:
There are many ways of using moving averages to identify
trading signals and normally different securities have different
characteristics so in some cases it may not be suitable to use aforementioned
interpretation of the moving average to analyze the chart as it may be better
to apply another periods for Moving Averages.
However,
most Common time periods for Moving averages whether using a single or couple
or triple moving averages are 9, 10, 13, 18, 20 and 21 for short term scale,
40, 55 and 89 for medium term scale and 100, 144, 200 for long term scale. The
time periods that better suite your needs can be obtained by comparing
different time periods ( common) based on the length of the cycle in which the
security repeat itself or the number of days that you may consider them as the
most referable data in your security's history. I suggest consulting an expert
instead of doing a lot of work.
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