Email of the day on moving averages
Comment of the Day

August 22 2017

Commentary by Eoin Treacy

Email of the day on moving averages

Hope you’re enjoying the warm weather in LA. We’ve had it quite cold here in Western Australia, the ‘sunshine state’.

Something I wanted to ask you at the last Chart Seminar in Singapore but did not get around to it.

You are an advocate of the weekly 200 MA(40wk) for gauging trend direction and overbought/oversold situations. Whilst this method appears to work reasonably well on the institutional type stocks, can it be used the same way on the mid to small cap and penny stocks?  I know of some people using 100MA(20wk) for the latter.

Many thanks in anticipation of an answer.

Eoin Treacy's view

Thank you for this question which may be of interest to the Collective. The orange trees in my garden were festooned with blossoms following the heavy rain this winter and there is a sizeable number of fruits developing, so we’re expecting a nice harvest of navels early next year.
We use the 200-day MA as a trend mean and indicator of trend direction. When the price becomes overextended, either above or below, relative to its mean the potential for a reversion necessarily increases. When the MA is trending higher it is simply a reflection of what prices have been doing on average over the given timeframe. 

Trading strategies dependent on moving average crossovers lag by definition. Using moving averages as levels where stops might be placed means selling after what might be a sizeable setback. More to the point the MA is also where support might be expected to return in a generally consistent medium-term uptrend and is therefore not usually the most appropriate place for a stop. 

I believe people tend to concentrate more on moving averages with short-term timeframes for two reasons. The first is because they are using leverage which should throw the focus on attention onto position sizing but can contribute to an acute sensitivity to drawdowns. The second is because the price if moving so quickly the 200-day MA is simply too far away to be practical. That tends to be particularly true of more volatile smaller cap shares which is why people use a 100-day MA. 

The additional point of course is that the shorter one’s moving average timeframe is, the shorter your holding period is likely to be so that is also worth considering. When engaging in any strategy ask yourself are you an investor or trader, leveraged or unleveraged and does your proposed course of action gel with the reality provided by the market?

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