Simple Moving Average Weighted Moving Average

Essential Technical 5Indicators to Master Mastering the basics of technical indicators Technical indicators can appear arcane, opaque and difficult to understand. But it needn’t be this way and once mastered they are indispensable tools for traders. Whilst the construction of indicators and oscillators is often complex, applying them and understanding how to use them to generate valuable trading signals is a lot more straightforward. In this short guide we will examine five different indicators and explain how to use them. Indicators can generally be divided into two camps – trend following and momentum. Trend following indicators tend to lag price action. Momentum measures the rate that prices change and is said to lead price action. The first two indicators in this guide are trend-following in nature. These are the different moving averages and Bollinger Bands. Our final two indicators – the RSI and Stochastics – are momentum indicators. The exception and one that we deal with third is the MACD, or moving average convergence divergence, which combines aspects of trend-following and momentum to produce one of the most popular and valuable technical indicators. 1 Moving Averages A moving average is one of the simplest and most popular indicators that traders use. The aim is to filter out ‘noise’ by smoothing short-term fluctuations in price action. A moving average is a lagging indicator – it is good at showing a trend but signals tend to be given after a change in the price action. There are 3 major types of moving average - the Simple or Arithmetic, the Weighted and the Exponential. These vary in their construction and tend to produce differing results using the same inputs, but their purpose is exactly the same. Time frames for moving averages vary and can be based on hours, days, weeks or even years. Intervals can also be changed, depending on the type of security being traded and the approach of the trader. For example, in equities trading 50-day and 200-day averages are common. In commodities, 4-day, 9-day and 18-day averages have become quite standard. Commonly closing prices are used but it is possible to use open, high, low or even typical prices as the basis for the average. In addition to providing trading signals, averages can act as support and resistance levels when determining price targets. Simple Moving Average Weighted Moving Average This simply takes an average of the closing price (for simplicity we’ll assume the close in all our examples) for each of the last n days of A weighted moving average differs by adding a weighting to each the average. So if you have a 20-day moving average, the SMA is the sum of all the closes divided by 20. The simple average reacts the day’s price. Usually this gives extra weight to the most recent day, slowest of the three – this means signals tend to be generated later, but it produces fewer false signals or ‘whipsaws’. and diminishing weighting to the preceding days. The below chart shows a simple 20-day moving average plotted against price action. For example, a 6-day weighted moving average could be weighted in sixths: the most recent day gets a weighting of 6/6, the fifth day FTSE 100 moving around its 20-day simple moving average is weighted 5/6, the fourth 4/6 and so on. In order to get to the moving average you multiply the input of day six by 6, the input of day five by 5, the input of day 4 by four and so on. These values are then added together and the sum divided by the sum of the multipliers – in this case 21. You don’t need to know how to calculate it; the point is just to understand that a weighted moving average set up like this gives added importance to the most recent day’s price action and as a result can produce signals sooner as changes in the trend appear earlier. Exponential Moving Average An exponential moving average gives less weighting to older inputs but never fully loses any of them. Although it is a good all-rounder, it is not as precise as a simple moving average it depends entirely on when the starting point is. EMAs are often the basis for more advanced indicators, which we will come to later. Source: ETX Capital 4 Key points about using moving averages Moving averages are useful in viewing trends and revealing Strong signals can be generated by employing more than one cross’ and signal significant strength in the market. A shorter potential reversals. A market that is above its moving average is average. For instance when a shorter moving average moves up average falling through a longer average that is also falling is called said to be in a rising trend. One that is below a moving average may through a longer average that is also rising, it is known as a ‘golden a dead cross and signals weakness. be said to be in a falling trend. Sideways trends can be identified when a market moves either side of a moving average. An example of a ‘golden cross’ when the 50-day SMA moves from below to above the 200-day SMA Signals can be generated when prices move through a moving average: a ‘buy’ signal when the security prices moves up through the average; a ‘sell’ signal if it falls beneath. However these are unreliable in isolation and most traders would seek confirmation, such as by looking at price patterns or applying filters; for instance a trader may decide that they need to see the market price close above the moving average for two consecutive days to consider the signal valid. As moving averages are lagging indicators, signals may be missed (applying filters can further delay signals being acted upon). One common practice to compensate for this characteristic is to advance the average by a number of periods. This can be done by using the ‘Horizontal Shift’ function when creating the moving average. In most markets the standard practice is to advance the moving average by 3 periods, but it is a matter of personal preference. Using more than one average is a common approach. Having a shorter and a longer time frame can help reveal more information Source: ETX Capital about a change in trend. For example, many traders employ 50- day and 200-day moving averages. As we will explore in the next two chapters, it is possible to create indicators from moving averages. 5 2 Bollinger Bands Bollinger Bands make use of moving averages to produce trading signals based on market volatility. Devised by John Bollinger, they are among the simplest technical indicators to use. Construction of Bollinger Bands A 20-day simple moving average of the security is plotted. Above and below these are the bands, which are 2 standard deviations away from the moving average. You don’t need to know about standard deviations to understand the indicator; suffice to say that this methodology ensures around 95% of all price action remains within the two bands. Using Bollinger Bands OVERBOUGHT/OVERSOLD USDJPY head and shoulders reversal pattern The most obvious way to look at Bollinger Bands is as an indicator of whether prices are overextended. Generally, you would say that as prices reach and then move beyond the upper and lower bands the market is becoming respectively overbought or oversold. However, it is worth noting that as prices touch bands they are as likely to continue to move beyond the bands as they are to move back within the range. SIGNALS You can use the bands for signals. For example if a reversal pattern on the price chart – such as a double top, head and shoulders, double bottom – occurs at the extreme of the band, it can be a stronger signal than if it occurs in the middle of the bands. For example, a double top with a first top beyond the upper band limit, with the second top forming below the upper band, may be considered a fairly strong signal that the market is about to reverse. (See chart opposite) Source: ETX Capital 7 NARROW/WIDE Bollinger Bands tend to widen as volatility increases and narrow the indicator in which direction you can expect this move to occur. when volatility recedes. Usually you can expect a sharp move Therefore it is useful to use this in conjunction with other technical in the price of the security when the bands tighten. But while a tools, such as momentum indicators, chart patterns, candlestick narrowing of the bands foreshadows a big move, it is unclear from formations, etc. USDJPY price action showing how tightening of bands can predict a sharp move PRICE TARGETS Bollinger Bands are useful in determining specific price targets. This is because prices have a tendency to swing from one extreme to the other. Therefore if the security’s price touches the upper band, a reasonable price target would constitute the lower band level. However, as with oversold and overbought indicators, it is Bands narrow worth noting that prices are as likely to continue to move beyond the bands as they are to retrace back between the two bands. Indeed, according to John Bollinger, when markets move outside the bands, a close outside the bands act as continuation signals, not reversal signals. Sharp move lower Source: ETX Capital 8 3 MACD Moving average convergence divergence – MACD – is one of the most popular tools for traders. It incorporates trend following and momentum characteristics. This indicator shows the relationship between two moving averages to identify changes in market trends.

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