| Some further nuances in interpretations.
Some
time ago we covered the topic of Moving averages and looked at the
different ways in which we could use them. In our subsequent
discussions on using the techniques, we also looked at the principal
ways of extracting market information. For those who missed out on the
earlier discussions, a brief recap is mentioned here:
Moving
averages are a trend following method of analyzing stock prices. Since
the averages are formed from a body of data prior to the current date,
the average will always lag the data rather than lead it. Hence the
term “trend following”.The moving average (MA) can be constructed for
any data point but by default, always refers to the closing price. The
moving average value is plotted on the price chart. Prices interrelate
with the average plot and constantly move above or below it. This is
called the crossover of price and average and constitutes the signal
for the system. If prices are above the average then it is considered
bullish and prices below the average indicate bearishness. Multiple
average techniques are also possible and generate additional signals
thru the crossover of the averages themselves.
There are other usages of Averages and that shall be discussed in the current article. Moving averages can be used as follows:
We
have so far discussed using it as a technique for analyzing prices. As
stated earlier, averages of any data can be made. One of the areas
where it is quite frequently used is in Volumes. Instead of looking at
absolute volume figures, one can look at average volumes as these will
help to iron out volume spikes, which are frequently seen.
Moving
averages can be used to construct bands around price moves, which can
then pinpoint one about possible support and resistance levels in the
future. This helps to iron out one of the shortcomings of the moving
average system – that of its inability to give targets for moves.
Averages
can be plotted with some displacement i.e. a day or more in the future.
As a result we shall have an average value for the day before the
trading starts for that day!
Moving averages of prices are
often substituted for the closing price when taken in as inputs for
oscillators. This helps to reduce the noise of the oscillator.
As
stated earlier, moving averages, by default, are of the closing prices.
But one can impart a further smoothing by taking an average price of
any combination of the open/low/high/close. Note that this will induce
a greater lag in the picture. Over the next two articles, we shall look
at these modifications.
Volume and Moving Averages
The
above chart is an example of how a moving average of the volume bars
would look like. Note in the chart above the HiLo prices, the middle
window has volumes are plotted as bars while in the lower window, the
volume is plotted as a moving average.It can be seen that the plot in
the lower window is a single smooth line which is much easier to
interpret as compared to the bar structure shown in the middle window.
Displaced Moving Averages
All
our discussions so far have been using the moving average being plotted
on the last day of the length of the data to be plotted. One can modify
this by shifting the plot of the derived moving average in any one
direction. Thus, we can have a shift up or down (a price shift) or left
or right (a time shift).Shifting to the right is the most commonly
followed technique. The vertical shifts leads to formation of bands
(taken up subsequently). There is little sense in a time shift to the
left since we do not require an average of older data and applying
current data average to older data is wrong logically. Therefore, the
MA shift is always to the right and this is known as the Displaced
Moving Average.
In the displaced MA, we plot the value of, say
a 5 period average, ahead by, say 5 days. This would be known as a 5 by
5 average. Hence the value of a five-day average is plotted on the 10th
data point, the next value is plotted on the 11th data point and so on.
Hence, at the end of the data series, we will actually have five days
of average values in hand. Hence, barring some volatile price moves, we
know roughly, where the MA will be over the next five days. This gives
us some points to measure the market by for that day. This can act as a
definite advantage in clueing one about the market trend. Every tool in
technical analysis is after all, only to do with increasing the odds of
knowing what the market will do next.
The difference between a normally plotted MA and a displaced MA would become evident from the following chart
The
blue line in the above chart is the Displaced MA while the Red line is
the normal MA. It can be seen that the displaced MA tracks the stock
from a bit further away and also, at the end, it has the values for a
few days more (in this case, 5 days as it is a 20 by 5 moving average).
Moving Averages used as inputs in Oscillators
We
have so far not covered the topic of Oscillators. These are another
section of technical analysis that seeks to measure the speed with
which stock prices are moving. By throwing up scenarios where the stock
prices are moving with increased or decreased speeds, clues are
obtained about the sustainability or otherwise of the trend.
Oscillators
generally use the closing prices as the default input. Depending upon
the type of oscillator we would get either a smooth plot or a noisy
plot. The smoothness of the plot would also depend upon the length of
the oscillator, also known as the period of the oscillator. It is seen
that the lower the period of the oscillator the greater is the noise of
the plot. Using moving averages is one way of overcoming this
difficulty. By taking in the MA of prices rather than the price itself
as the input, we obtain a smoother plot. Thus one need not sacrifice
the sensitivity of shorter time frames.
The following chart should explain the differences.
The
above chart shows the Prices plotted with two oscillator sub graphs.
The one in the middle (red line) is the normally plotted indicator
chart using the closing prices of the underlying price chart. The plot
in the sub window on top (blue line) is the same oscillator of the same
period but this time, one has used a 5 period average of the prices as
the input for calculating the oscillator. One can immediately note the
smoother plot of the blue line chart as compared to the red line chart.
It is considerably easier to read the blue line chart as it shows a
more measured movement. Thus, using a price smoothening tool has helped
to smooth out the plot of a price derivative such as the oscillator
also.
We shall take up the MA bands in the next article. |