One of the most talked about indicators and perhaps the most used are moving averages. Commonly used moving averages are the 8 or 10 period, 20 period, 40 period or 50 period, and 200 period. Of these the 20ma and 200ma are probably the most followed by traders and 50 and 200 ma’s by investors.
They are common because they are so easy to set up and information about them is everywhere. The next point is crucial, many people work very hard for their money and then without any reflection or research they use something they read about moving averages to trade and risk that same money.
One of the most ‘misdirected’ uses of an indicator occurs when someone looks at crossovers on moving averages. There are many ‘stock buying systems’ that tout this a a strategy and a trigger signal to buy stocks. “I bet countless people have paid thousands of dollars for trading systems that exclusively use this concept as a buy and sell signal”, says Kurt Capra, moderator of Pristine.coms futures trading room. “Any trader with some knowledge of the way moving averages work would instantly recognize that by the time such moving averages “crossover”, that the price action has already occurred,” he continues. In some instances, such signals might provide a continuation of momentum, but in general, by the time you get the signal, it’s too late. That’s the typical use of an indicator as a “price predictor”.
Capra brings up a crucial point for new and developing traders. When he says that, “any trader with some knowledge of the way moving averages work would instantly recognize that by the time distant average cross over one another that the price action has already occurred”, he mean that the entry would have already been missed. The point to be followed up on here is before anyone should take and use information they get from the internet, a book, or paid for in a seminar to risk their hard earned money they should take a look at it on real charts. They should a paper trade it before risking real money. If more people did their would be far less people trying to use this strategy. In fact, if they just looked at some of these on past charts (easy to find) they would see this is too late to get in on most of them.
The idea in trading is to enter at the beginning of a move, not buy it from those who did later on to secure their profit when a large portion of the move is over or even done with. Some more information on this is in the recommended articles section.
If Capra’ comments are confusing you have to come to realize that successful traders are not in this business looking to ‘predict’. Their objective is to analyze opportunities, evaluate odds, and manage our trades. For traders, a better and more objective use of moving averages is to use them as trend following tools. Looking at a stock that presents a rising 20 period moving average will quickly give us information about the trend of that stock, even without having to look at months of price data. Then, once we know the trend we can use the price data to find reliable opportunities for trading.
So, the next time you look at a chart that includes your favorite indicator, try to use the information provided by it in such a way that helps you to evaluate the securities trend, momentum, and volatility. Don’t try to use it to predict prices. In this way, you’re bringing a level of objectivity to your trading that will serve you better.
Trade with a plan.