and the charts associated with it in one breath and then in the
next reveal how much in (perhaps unconscious) thrall to these
ideas they really are. They bring to mind the old joke about
the man who complains to his doctor that his wife has for several
years believed she's a chicken. He would have sought help
sooner, he says, "but we needed the eggs." Without reading
too much into this story except that we do sometimes seem to
need the notions of technical analysis, let me finally proceed
to examine some of these notions.
Investors naturally want to get a broad picture of the
movement of the market and of particular stocks, and for this
the simple technical notion of a moving average is helpful.
When a quantity varies over time (such as the stock price of a
company, the noontime temperature in Milwaukee, or the
cost of cabbage in Kiev), one can, each day, average its values
over, say, the previous 200 days. The averages in this sequence
vary and hence the sequence is called a moving average,
but the value of such a moving average is that it doesn't
move nearly as much as the stock price itself; it might be
termed the phlegmatic average.
For illustration, consider the three-day moving average of a
company whose stock is very volatile, its closing prices on
successive days being: 8, 9, 10, 5, 6, 9. On the day the stock
closed at 10, its three-day moving average was (8 + 9 + 10)/3
or 9. On the next day, when the stock closed at 5, its threeday
moving average was (9 + 10 + 5)/3 or 8. When the stock
closed at 6, its three-day moving average was (10 + 5 + 6)/3
or 7. And the next day, when it closed at 9, its three-day moving
average was (5 + 6 + 9)/3 or 6.67.
If the stock oscillates in a very regular way and you are
careful about the length of time you pick, the moving average
may barely move at all. Consider an extreme case, the twentyday
moving average of a company whose closing stock prices
oscillate with metronomic regularity. On successive days they
are: 51, 52, 53, 54, 55, 54, 53, 52, 51, 50, 49, 48, 47, 46, 45,
46, 47, 48, 49, 50, 51, 52, 53, and so on, moving up and
down around a price of 50. The twenty-day moving average
on the day marked in bold is 50 (obtained by averaging the
20 numbers up to and including it). Likewise, the twenty-day
moving average on the next day, when the stock is at 51, is
also 50. It's the same for the next day. In fact, if the stock
price oscillates in this regular way and repeats itself every
twenty days, the twenty-day moving average is always 50.
There are variations in the definition of moving averages
(some weight recent days more heavily, others take account of
the varying volatility of the stock), but they are all designed to
smooth out the day-to-day fluctuations in a stock's price in
order to give the investor a look at broader trends. Software
and online sites allow easy comparison of the stock's daily
movements with the slower-moving averages.
Technical analysts use the moving average to generate
buy-sell rules. The most common such rule directs you to
buy a stock when it exceeds its X-day moving average. Context
determines the value of X, which is usually 10, 50, or
200 days. Conversely, the rule directs you to sell when the
stock falls below its X-day moving average. With the regularly
oscillating stock above, the rule would not lead to any
gains or losses. It would call for you to buy the stock when it
moves from 50, its moving average, to 51, and for you to sell
it when it moves from 50 to 49. In the previous example of
the three-day moving average, the rule would require that
you buy the stock at the end of the third day and sell it at the
end of the fourth, leading in this particular case to a loss.
The rule can work well when a stock fluctuates about a
long-term upward- or downward-sloping course. The rationale
for it is that trends should be followed, and that when a stock
moves above its X-day moving average, this movement signals
that a bullish trend has begun. Conversely, when a stock moves
below its X-day moving average, the movement signals a bearish
trend. I reiterate that mere upward (downward) movement
of the stock is not enough to signal a buy (sell) order; a stock
must move above (below) its moving average.
Alas, had I followed any sort of moving average rule, I
would have been out of WCOM, which moved more or less
steadily downhill for almost three years, long before I lost
most of my investment in it. In fact, I never would have
bought it in the first place. The security guard mentioned in
chapter 1 did, in effect, use such a rule to justify the sale of
the stocks in his pension plan.
There are a few studies, which I'll get to later, suggesting
that a moving average rule is sometimes moderately effective.
Even so, however, there are several problems. One is that it can
cost you a lot in commissions if the stock price hovers around
the moving average and moves through it many times in both
directions. Thus you have to modify the rule so that the price
must move above or below its moving average by a non-trivial
amount. You must also decide whether to buy at the end of the
day the price exceeds the moving average or at the beginning
of the next day or later still.
You can mine the voluminous time-series data on stock
prices to find the X that has given the best returns for adhering
to the X-day moving average buy-sell rule. Or you can
complicate the rule by comparing moving averages over different
intervals and buying or selling when these averages
cross each other. You can even adapt the idea to day trading
by using X-minute moving averages defined in terms of the
mathematical notion of an integral. Optimal strategies can always
be found after the fact. The trick is getting something
that will work in the future; everyone's very good at predicting
the past. This brings us to the most trenchant criticism of
the moving-average strategy. If the stock market is efficient,
that is, if information about a stock is almost instantaneously
incorporated into its price, then any stock's future moves will
be determined by random external events. Its past behavior,
in particular its moving average, is irrelevant, and its future
movement is unpredictable.
Read More : Moving Averages, Big Picture
