The 7 Pitfalls of Moving Averages

5.1

7 ratings

2,584 views

Article
Beginner
1

Kalen Smith

08 Jan, 2016

in Technical Analysis and 1 more

A moving average is the average price of a security over a specified period of time. Analysts frequently use moving averages as an analytical tool to make it easier to follow market trends, as securities move up and down.

Moving averages can establish trends and measure momentum, therefore, they can be used to indicate when an investor should buy or sell a specific security. Investors can also use moving averages to identify support or resistance points in order to gauge when prices are likely to change direction. By studying historical trading ranges, support and resistance points are established where the price of a security reversed its upward or downward trend, in the past. These points are then used to make, buy or sell decisions.

Unfortunately, moving averages are not perfect tools for establishing trends and they present many subtle, but significant, risks to investors. Moreover, moving averages do not apply to all types of companies and industries.

Some of the key disadvantages of moving averages include:

1. Moving averages draw trends from past information. They don't take into account changes that may affect a security's future performance, such as new competitors, higher or lower demand for products in the industry and changes in the managerial structure of the company.

2. Ideally, a moving average will show a consistent change in the price of a security, over time. Unfortunately, moving averages don't work for all companies, especially for those in very volatile industries or those that are heavily influenced by current events. This is especially true for the oil industry and highly speculative industries, in general.

3. Moving averages can be spread out over any time period. However, this can be problematic because the general trend can change significantly depending on the time period used. Shorter time frames have more volatility, whereas longer time frames have less volatility, but don't account for new changes in the market. Investors must be careful which time frame they choose, to make sure the trend is clear and relevant.

4. An on-going debate is whether or not more emphasis should be placed on the most recent days in the time period. Many feel that recent data better reflects the direction the security is moving, while others feel that giving some days more weight than others, incorrectly biases the trend. Investors who use different methods for calculating averages may draw completely different trends.

5. Many investors argue that technical analysis is a meaningless way to predict market behavior. They say the market has no memory and the past is not an indicator of the future. Moreover, there is substantial research to back this up. For example, Roy Nersesian conducted a study with five different strategies using moving averages. The success rate of each strategy varied between 37% and 66%. This research suggests that moving averages only yield results about half of the time, which could make using them a risky proposition for effectively timing the stock market.

6. Securities often show a cyclical pattern of behavior. This is also true for utility companies, which have steady demand for their product year-to-year, but experience strong seasonal changes. Although moving averages can help smooth out these trends, they can also hide the fact that the security is trending in an oscillatory pattern.

7. The purpose of any trend is to predict where the price of a security will be in the future. If a security is not trending in either direction, it doesn't provide an opportunity to profit from either buying or short selling. The only way an investor may be able to profit would be to implement a sophisticated, options-based strategy that relies on the price remaining steady.

You need to be logged in to post comments or rate this article.

Questions

1. Moving averages draw trends from past information. They don't take into account changes that may affect a security's future performance, such as new competitors, higher or lower demand for products in the industry and changes in the managerial structure of the company.

Doesn't historical data already have the news priced into it? Whatever news that happened during that time will have caused or not caused any changes in the market that results in the price that it ended up being, wouldn't it?

2. Ideally, a moving average will show a consistent change in the price of a security, over time. Unfortunately, moving averages don't work for all companies, especially for those in very volatile industries or those that are heavily influenced by current events. This is especially true for the oil industry and highly speculative industries, in general.

What is meant by a moving average will show a consistent change in price of a security, over time"? Securities do not change price at a consistent rate? If an exponential moving average is essentially and a derivative of a stochastic process mapping a security, then if the security changes price rapidly, so shall the EMA. Derivatives (calculus) map the rates of changes at a given in an underlying function or process. Using a discretized time step analysis, If a stock has a price of $50.00/share at t=0, $50.50 at t=1, $51.51 at t=2, then it does not have a consistent price change. The EMA or any other form, as it was not described which type of moving average was being used, wil reflect an acceleration in price. The derivative at t=1 = 1% and at t=2 = %2. I suppose I do not understand where the discrepancy and; thus, the problem lies with the part in red.

5. Many investors argue that technical analysis is a meaningless way to predict market behavior. They say the market has no memory and the past is not an indicator of the future. Moreover, there is substantial research to back this up. For example, Roy Nersesian conducted a study with five different strategies using moving averages. [color=]The success rate of each strategy varied between 37% and 66%. This research suggests that moving averages only yield results about half of the time, which could make using them a risky proposition for effectively timing the stock market.

If technical analysis has no value and the market has no memory, then what is the point of historical data? Why bother keeping historical data if it is irrelevant to the future? Many firms spend a great deal of money keeping and tryin maintain accurate historical data. Many services charge an arm and a leg for it. Does this mean that they are tantamount to snake oil salesmen? Additonally, wouldn't that make charting and the like obsolete as they rely upon historical data no matter how short of a time frame you look back?

I would be curious to know which strategies were applied specifically? What types of moving averages were used and which permutations? EMAs, WEMAs, SMAs? How long was the backtest period?

Jan 11, 2016

Member (2541 posts)

Loading...