The Art & Science of Technical Analysis: Market Structure, Price Action & Trading Strategies

APPENDIX B

A Deeper Look at Moving Averages and the MACD

The charts and the discussion that follow may look a little strange, but the thought process is important. Too many times, traders use indicators or tools on their charts that they do not understand. Rules are developed based on the action of a squiggly line without fully understanding what that line measures and represents. Though some traders will find some success with an approach like this, it misses much of the potential in these tools. To fully understand a technical tool, it is useful to peer deeply into its construction, and to understand how it reacts to changes in the underlying market. One of the best ways to do this is to “feed” an indicator an artificially created dataset that focuses on specific types of market action. Think of this as a way to look at the indicator in a laboratory environment, isolating and controlling for various influences.

MOVING AVERAGES

If you want to really understand the tools you are using and how they will react to extreme situations, it helps to understand how they will react in the most simple, basic contexts as well. Of course, everyone grasps the basics of moving averages: add higher prices and the average will go up. When price flattens out, the average eventually will flatten, too. When price turns down, it will cut through the moving average, and, at some point, it will start pulling the average down with it. This is all simple, but it is not the point. The point is to build ...