Chapter 6

Moving Averages

For many years now, one of the most popular trend-following methods has been the moving average. The simplicity of its construction and the ease of its interpretation contribute to its widespread usage and acceptance. Unfortunately, this tool's success is derived from a particular market's ability to trend. My research indicates that markets generally move in trading ranges and trend much less frequently. Historical observations suggest that, approximately 75 to 80 percent of the time, price of a particular security tends to move in a trading range. On the other hand, 20 to 25 percent of the time, price trends are either up or down. Furthermore, additional research shows that price accelerates in a downtrend generally about two to two and a half times faster them price in an uptrend. This phenomenon can be easily accounted for by the fact that whereas investors typically accumulate a position over a period of time, their recognition of a price decline is immediate and their tendency is to liquidate the entire position at one time.

The most common and basic calculation of the moving average is arithmatic and involves only adding together the closing prices of a security over a prescribed period of time, dividing this sum by the total number of entries, and then plotting that period's value on a chart coincident with that interval's price range. Unfortunately, this is the common practice but it is not necessarily the ideal or the correct one. Most market ...

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