Level 2 Patterns & indicators · Part 5/9

Moving Averages

The moving average is the oldest and most widely used indicator. It answers exactly one question: where did price sit on average over the last n periods?

SMA and EMA

The simple moving average (SMA) averages the last n closes with equal weight. The exponential one (EMA) weights recent prices more heavily; it reacts faster and turns earlier, but is wrong more often.

Which is “better” depends solely on what you want to buy: faster response or fewer false signals. You cannot have both – choosing between SMA and EMA is not an optimisation but a trade.

The period

Common values are 20, 50, 100 and 200 periods. These numbers have no mathematical justification; they are convention – and partly work because many participants watch the same lines.

A 200-day average shows long-term direction and is rarely crossed. A 20-day average hugs price and is crossed constantly. What matters is that the period is fixed before the analysis. Choosing the period that would have worked best in hindsight fits a parameter to the past and teaches you nothing about the future.

Crossovers

The short average (dark green) reacts faster, the long one (violet) more slowly. (1) When the short crosses above the long it is called a bullish crossover, (2) the reverse a bearish one. Both lines are pure history: they smooth prices that already traded. The price for that is lag — in sideways markets it produces false signal after false signal.

When a short average crosses a long one from below it is called a bullish crossover; at periods 50 and 200 the name golden cross has stuck, and death cross for the reverse.

The names are more spectacular than the substance. A crossover is a mechanical consequence of price movement, not additional information: it occurs after price has already moved substantially. Studies of these signals routinely find their advantage over plain buy-and-hold to be small and unstable across periods.

The built-in lag

Every average is history. A 50-day average has its centre of mass roughly 25 days in the past – it cannot turn earlier than price, only later.

That produces systematic behaviour:

In trends, averages work well, because lag costs little.
In sideways phases, they produce false signal after false signal, because price keeps crossing back and forth.

Since sideways phases occupy most of the time, the hit rate of crossover systems is typically low while a few large trends carry the result. Looking only at hit rate makes a working system look broken – expectancy says otherwise.

Sensible applications

Trend filter: only take positions in the direction of the higher average. That reduces the number of opportunities and raises their quality.
Dynamic zone: in strong trends price often runs along an average. The area around the line then replaces a horizontal support.
Slope instead of position: not just whether price is above the line, but whether the line is rising. Slope is the more stable quantity.

The following article covers indicators that track speed rather than direction: oscillators.