by Joe Sharp,Ph.D.
Traders are resigned to moving averages being behind the
price action,but that neednít always be the case. Hereís an
algebraic technique to make your averages more responsive
to price movement - and a better aid in decision--making.
Moving averages serve two main
purposes: to show the underlying
security value after noise has
been filtered out and, implicitly,
to delay decisions to reduce
whipsaws. However, that delay
frustrates traders who must make
decisions based on what is
happening right then and there.
You can fix that. Iíll show you a corrected moving average
that can follow trends accurately. Youíll have to endure a
little math to get the idea,or you can use the spreadsheet Iíve
provided in Sidebar 1.
THE OLD WAY
First,I want to show you a simple example of a problem thatís
easy to calculate by hand. It can be seen in the spreadsheet in
Figure 1, and Iím using it here just to introduce the problem
and suggest how to fix it.
Start the column marked "Day" at day zero and run it
downward to 19. Then,starting at day 1, give the security
value column values from one up to 10 and back down to one.
Compute a simple two-day moving average by hand. The
first value, for example, in column C is (1+0)/2 =0.5. On day
2, itís (2+1)/2 =1.5, and so on.
The Error column is the difference between the securityís
price and the average. For the first line, thatís 1 -0.5 =0.5. The
column shows that the average will never be able to catch up
with the rising and falling ramp; it will always lag behind the
correct value of the underlying security by half the change in
the period included in the average. Similarly, simple moving
averages lag behind falling security values.