Definitions: Multiple Moving Averages: Stock and Bond Trading Using Technical Analysis of Price
This article is a companion piece to “Definitions of Investment: Moving Averages”. This article elaborates how and why technical investors may employ these techniques successfully. For simplicity all trades described are long trades. Short positions require a reversal of the moving average values.
What are Multiple Moving Averages?
Moving averages are consistently averaged prices of traded securities ( stocks, bond, commodities or currencies) that may or may not be weighted to reduce the data lag. Moving averages are chosen because backtesting found an acceptable return relative to risk. Proper risk management includes initial position risk, stop risk, and exit risk. Whatever time frame the investor uses, daily, weekly, or monthly charts; or 5 minute, daily, 10 week or 44 week moving averages this simple but effective technique needs to be developed through backtesting to achieve the investor’s goals. Multiple moving averages usually employ two or three moving averages.
What is the Difference Between a Dual and Triple Moving Average Technical Trading System?
The major difference between the two and three moving average technique is that the three moving average technique has a quicker exit strategy. When the shortest moving average crosses below the middle moving average the trade is exited. The dual or two average system is more robust with the possibility of larger gains but usually at the expense of greater drawdowns. Drawdowns in this sense refers to the opportunity loss from a high price in a bond or stock to the exit signal. Importantly, risk control in the initial long or short position consistently applied results in many small losses that are offset by fewer but larger gains. Trading with moving averages is like the baseball slugger syndrome: The value of the home run more than offsets the lost opportunity of the more frequent strikeout.
How are Dual Moving Trades Initiated and Exited?
A single moving average would compare prices to the moving average. The investor could buy when price rises above the moving average and sell when prices decline below the line. A better solution would be to use two moving averages. The longer moving average will be backtested against the longer trend of the market. The shorter trend is of significant importance because it confirms the continuation of the longer term trend.
The Triple Moving Average System
The third moving average must cross above the intermediate average for the trade to be initiated. As described above the triple moving average only requires the shortest moving average to fall below the intermediate moving average for an exit. As long as the intermediate trend stays above the long moving average the trend can be re-instituted when the shorter moving average regains strength above the intermediate trend. The investment theory is the long term lift to a stock probably cannot continue if the shorter term trend declines below that of the long term moving average. This system is less risky but suffers greater drawdowns from the oscillation of the short moving average.
Why Are Multiple Moving Average Techniques Popular
Moving averages only capture trends once they are underway and after the trend has reversed. The time lag of the moving averages necessary to find a trend is in place implies that most but not all of a major move will be captured. Whipsaws and false starts relative to one’s risk strategy will create further drag on returns. But the benefits of capturing the major trend found by moving average strategies is well documented for long term traders.