Moving averages are one of the most frequently used tools in technical analysis. The technical analyst relies on price and volume data to identify price trends in stocks, bonds, currencies and other financial instruments. A moving average is derived from the financial instrument's price history and helps the technical analyst visualize intermediate and long-term trends. Displacing a moving average can make this potent tool even more useful.
Calculating Moving Averages
A moving average is the average price of a financial instrument over a specific number of past days. For example, a five-day moving average, calculated at the close of trading on Friday, is the average price of the five daily prices from Monday to Friday. Ten-, 30-, 100- and 200-day moving averages are the most common. Moving averages help smooth out abrupt price moves. A sudden jump in price on any given day has less of an effect on the moving average than on the stock's daily price graph, since the impact is diluted. This helps the analyst visualize the general direction of price changes.
Displacing a moving average involves shifting it to the left or right by a certain number of days. To displace a 10-day moving average by plus three days, you move the line representing the moving average to the right on the price graph by three days. A technical analyst uses displacement if, historically, the moving average has triggered buy or sell signals too early or too late. By visualizing where those same signals would have been generated if the analyst had used a displaced moving average, the accuracy of the analysis can be greatly enhanced.
Price and Moving Average Technique
The most basic method of using a moving average line or a displaced moving average line to generate buy and sell signals is to compare it to the daily price line. In an up market, the price of the security is expected to continue its climb as long as the price line remains above the moving average line. Similarly, a downtrend is in effect as long as prices remain below the moving average. If the price, which had been above the moving average, crosses the moving average line downward, the chart generates a sell signal. A crossover from bottom to top results in a buy signal.
Two Moving Averages
The analyst can also utilize two moving averages. In this technique, a short-term and a relatively longer-term average are used; for example, 30- and 100-day moving averages. As long as the short-term average remains above the long-term one, the up trend is expected to continue, while a sell signal is generated if the short-term average crosses the long-term one toward the downside. A crossover in the opposite direction generates a sell signal. One or both of these averages can be displaced. The decision to displace one or both as well as the averages' duration are assessed through trial and error.
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