Moving Averages by Dennis Peterson
Understanding the basics can help you trade moving averages much more efficiently.
Moving averages — so simple, yet they can lead to disaster if they are used incorrectly. The secret is in the selection of the time period. Selecting a time period after backtesting for the past 20 years of data, for example, may not give you the answer you seek. Moving averages are trend-following devices, and when you use them you need to be sure you are in a trend. Some commodities trend better than equities; for example, look at the trend of yen in Figure 1.
For a year and a half, the yen was in a downtrend, and if you start looking earlier, at 1995, the overall trend is even longer. There aren’t many equity charts with a prolonged, well-behaved downtrend — something that declines at the same rate for more than six months. The key word here is rate. If the rate of change is jumping around, then moving averages have to catch up. For example, when someone tells me he uses a moving average period that has worked well for the last 20 years, I have to wonder what would make him think
that today’s rate can be compared to yesterday’s, or for that matter, the last 20 years. And what would make him think that prices go up as fast as they go down?