Trend-following traders, at one point, exclusively used some form of moving averages either for entry, exit, or a combination thereof. However, as computers evolved and more people and firms entered the market, moving average systems lost some of their initial luster. Ed Seykota, a legendary technical trader, used a modified Donchian1 moving average system and only used the day’s closing prices as the underlying data for the system. I would contend that it does not matter whether you use moving averages or any other technical tool for your system. What really matters is that you understand it intimately and can adapt it to your own needs – The more simple the system, the greater the likelihood of you understanding it and spotting errors.
Moving averages are smoothing mechanisms and can remove some of the noise in the markets. They can also signal important changes in trends or can show increases or decreases in liquidity. The way you use moving averages will depend completely on the type of trader you are and the system that you follow. If you plan to use a pre-packaged software system that incorporates moving averages, independently verify the calculations using your own program. Make sure that you account for everything that the purchased software does or does not do. Personally, I do not believe you should ever use a system developed by someone else because the systems you can buy today are based on the developer’s assumptions. However, there can be certain advantages, especially if they incorporate a few data sources. They can act as redundancy tools, verifying your data and vice versa.
The following guidelines may seem simplistic and taken as self-evident by many, but I believe that they are essential for all traders, whether novice or experienced.
- Never enter/exit a trade on the same day that you calculate a moving average point. It is preferable to use the preceding day’s data point to evaluate a position.
- There is no need to use complicated moving average calculations. Test performance using simple moving averages and then re-test using adaptive, exponential, or weighted moving averages. Usually the results will be indistinguishable.
- For cross-over techniques, validate the cross-over before contemplating entry/exit. Usually, experienced traders will force short-term price moves back to shake out weak hands. Determine a consistent and noticeable number of days for validation purposes.
- Understand that moving averages often provide false signals and develop a mechanism in order to cope with this fact.
- Never go against the long-term moving average. Instead, use small price corrections to the average to establish new longs/shorts in the direction of the trend.
1. Richard Donchian has been mentioned as the pioneer of trend-following and he developed a 5 day / 20 day moving average cross-over system.