Chapter Objectives

By the end of this chapter, you should

• Be aware of how moving averages are used to identify trends
• Be able to calculate a simple moving average
• Be able to calculate an exponential moving average
• Be familiar with the concept of directional movement
• Be familiar with the construction of envelopes, bands, and price channels

One of the most successful methods of identifying and profiting from trends is the use of moving averages. A moving average is a constant period average, usually of prices, that is calculated for each successive chart period interval. The result, when plotted on a price chart, shows a smooth line representing the successive, average prices. Moving averages dampen the effects of short-term oscillations. Many of the most successful technical investment managers use moving averages to determine when trends are changing direction. Moving averages are especially useful in markets that have a tendency to trend.

Moving averages have been tested by academics and shown to have statistical significance. Brock, Lakonishok, and LeBaron (1992) were the first to demonstrate, using modern statistical bias-reducing methods, that moving average crossover signals have intrinsic value. As with most academic studies, the results of Brock, Lakonishok, and LeBaron’s have been somewhat controversial. Even though some have since criticized their study, other researchers have validated their results. (Incidentally, the Brock, Lakonishok, and LeBaron study provides one of the more useful arguments against the Random Walk and Efficient Markets hypotheses.) Although the Brock, Lakonishok, and LeBaron study focused on the Dow Jones Industrials, later studies have used moving average crossover systems for market data in other countries with generally the same positive results. Detry and Gregoire (2001) provided a summary of these studies.

There obviously is something to moving averages. Traders and trend investors, of course, have known all this for many years, but technical analysts now feel more comfort in what they have been doing. In this chapter, we discuss some of the moving average methods and strategies that technical analysts use, as well as introduce some variations on moving averages, such as Bollinger Bands, envelopes, and directional movement indicators.

Source: Kirkpatrick II Charles D., Dahlquist Julie R. (2015), Technical Analysis: The Complete Resource for Financial Market Technicians, FT Press; 3rd edition.