Sunday, 27 October 2013
Misconceptions About Moving Average
Moving average is a widely-used technical analysis indicator. Different systems and school of thoughts use different days moving average, but the more commonly used ones are 20, 50 and 200 days.
Statistical studies and academic research showed that MA is useful in identifying reversal of trend and serve as a strong support or resistance for stock price. 20 and 50 day MA signifies short term trend of the market while 200 days represent mega trend that could last a few years. I have also heard some experts shared that investing based on MA analysis has the highest statistics probability of profits among all the technical indicators.
This is where many layman investors have big time misconception about MA and the problem lies in mixing up on the causal relationship between stock price and its MA.
If we dive deep into the mechanism of MA, we will know that it is a lagging indicator. Movement of MA lags movement of share price. A rise (fall) in share price causes the MA to rise (fall) correspondingly. In other words, the causal relationship between MA and share price is such that share price movement brings about MA movement, not the other way round! (This explains why the price chart and MA will always show a nicely synchronised pattern on hindsight)
Alarmingly, many investors are making investment decisions based on MA solely, and in turn lament its bad accuracy and lose money. That is to be expected. How can one, upon seeing vehicles that always stop on red traffic light, conclude that the next time he sees a car slowing or stopping, there will always be a red traffic light ahead? I will term this as 本末倒置。
In my opinion, there needs to be 2 conditions in place if investors would want to use MA as the only evaluation criteria for their investment.
Firstly, he must have a proper cut-loss system strictly adhered to, and must have the mental and behavioural discipline to follow the system in his transactions. As the MA has no predictive power in share price movements, you can never be sure that a share price that is rising above its 20, 50, 200 day MA will not reverse its course the next day or next week. So a cut-loss system is important.
Another more important point to note, in my opinion, is to recognise that your MA investment plan must be as identical as possible, to the conditions set out in those academic studies claiming MA investing has a high success rates, in order to reap profits.
High success rate, is about probability. When it is about probability, your transaction numbers need to be large enough to smooth out the randomness and show a similar probability of success. If the experts claim that ‘following 20d MA cuts 50d MA buy decisions will bring you profit 6 out of 10 trades’, you better be transacting much more frequently for such statistical numbers to show through. If you only buy 5 times when 20d cuts 50d so far, do not be surprised if you end up losing money in all the 5 trades and blame the MA or the research studies. Whether you have the time, energy and interest in trading so frequently is another issue.
Both points are inter-linked. You can’t have successful MA investment records without a large enough number of trades. And you can’t execute large number of trades without screwing-up, if you do not have a system, and the mental discipline to follow through with your system.
So, be clear that MA does not precede the price movement. It, at most, increases the chances and probability that the share price will move as you expected (be it rise or fall), based on the MA analysis. To capitalise on such increased probability to earn a profit, one needs to execute large number of transactions with a strictly followed cut-loss rules.
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