V.14:6 (253-257) The Derivative Moving Average by Adam White

Here's a strategic variation of the tried-and-true simple moving average that uses a moving average for entry signals and the trend analysis index for exit signals. By Adam White

To get that all-important edge over other market participants, the creative investor must use methods that other investors are not. Thus, as a technician I am always looking for different twists on reliable indicators and trading strategies. Let me explain the derivative moving average, a new twist to one of the most reliable and best-known indicators of all, the simple moving averageY´.

Moving averages are widely used because they are simple to calculate, intuitive to apply and, most important for the trend-follower, allow profits to run while cutting losses. However, moving averages also suffer from two important flaws when used in a traditional trend-following capacity. First, consider the common trading strategy in which the trader enters into a position when the market crosses a moving average in the desired direction and exits when the market crosses a moving average in the opposite direction. Markets typically spend most of the time moving sideways, not trending. In this case, the market can cross the moving average a number of times in quick succession, producing a string of whipsawY´ losses. Call this the whipsaw flaw .

The second flaw of moving averages is due to their natural lag. By definition, a simple moving average trails price by a period equal to half its length, and so, the market can move quite a distance after reversing from its extreme to the price at which it crosses the moving average. This can give back much of the equity earned by the trade. Call this the equity surrender flaw . Figure 1 illustrates these two limitations.