Use This Simple Trading Tool To Profit In 2023
Moving averages (MAs) are one of the most popular trading tools. Their popularity with traders is in part due to their simplicity. Before there were calculators or computers, a 10-day simple moving average could be found by adding up the last 10 closing prices and moving the decimal point one space to the left.
Today, traders are able to calculate and use MAs of a variety of lengths, using many variations of the simple calculation. In a moment, we’ll apply this a simple version of this concept to the market today. But first, let’s take a look at some of the different ways they’re used…
Understanding Different Types of Moving Averages
Rather than just adding up numbers and dividing by the total number, there are at least four other possible ways to find a moving average:
1. Exponential Moving Average: Assigns a greater weight to the more recent market action in an effort to be more responsive to changes in the trend.
2. Weighted Moving Average: Allows users to decide which data should be overweighted and allows for the weighting values to be changed.
3. Triangular Moving Average: Weights the middle of the data more heavily.
4. Adaptive Moving Average: Uses smoothing factors to adjust the number of days used in the calculations to current market conditions.
Each method has its proponents and each of the four methods adds a level of complexity to what was originally a simple indicator. Complexity is only okay if you understand it properly and it adds value.
Visually, it looks like the different moving averages move in the same general direction. The chart below is a weekly chart of the SPDR S&P 500 ETF (NYSE: SPY) with the prices hidden so all we see are the moving averages. This eliminates the clutter on the chart and makes it possible to see that the moving averages rise and fall at the same time.
Large delays at bottoms are one of the most significant drawbacks of trading with a moving average. The adaptive moving average, the thin red line, stands out as consistently lagging the simple MA, shown as the thick blue line. At the bottom in 2009, the exponential MA, the brown line, was the last to signal a buy. That signal came after SPY gained more than 35%. The other MAs signaled a buy after a gain of 25%.
The other significant drawback is that there are a large number of small trades in a sideways market. Based on the visual comparison, we can say that the averages are all close to each other. More detailed quantitative testing of the various MAs is required to develop a stronger opinion as to which one is best for your purposes.
How To Use Moving Averages To Your Advantage
An important thing to note, however, is that this indicator will not call the top of the market. In fact, because it is calculated with historical data, it is impossible for any MA to signal at the exact top or bottom.
There is no way to fully eliminate the problems associated with moving averages. The best way to use them is to apply them as a long-only “buy” or “sell” signal (i.e. not short). No matter what type of MA is used, when the prices are below the MA, the chances of profitable buys are low.
With that said, let’s take at a chart of SPY using a simple 50 and 200-day MA.
At the time of this writing, the SPY sits above both MAs. You can see the 50-day MA (blue line) beginning to cross back above the 200-day (red) — a bullish sign. Looking further back, you can see when the SPY crossed the 200-day MA pretty close to the beginning of the recent bear market.
The last time the 200-day MA was violated was during the pandemic-fueled selloff in 2020. By simply following this, it would have proved to be a timely sell signal. And while you would have missed the initial rally, you would have still captured a lot of upside by using this as an “all clear” signal to get back in.
Based on this indicator alone, we should be concerned if the SPY closes below the 200-day MA. Some traders will use this as a reason to sell by itself. We don’t necessarily recommend that — technical-minded traders may want to use other tools (like RSI, for example) to confirm this signal before selling.
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