Moving Averages

Moving averages (MA) provide a very simple means of smoothing a price series and making any trends more discernible. Typically, MA are calculated using the close of the time period. A simple MA is defined as the average close the past N time periods, ending with the current time period. For example, a 21-day MA would be equal to the average of the past 21 closes. The term, moving average, refers to the fact that the set of numbers being averaged is continuously moving through time. Figure 5 illustrates a 21-day MA superimposed on the March '00 Feeder Cattle chart. Note that the MA clearly reflects the trend and smoothes out the fluctuations in the data. In choppy markets, MA's will tend to oscillate in a general sideways pattern as you can see during the months of July '99 and Oct/Nov ?99.

One very simple method of using MA's to define trends is based on the direction of change in a MA's value relative to the previous day. For example, a MA (and by implication the trend) would be considered to be rising if today's value was higher than yesterday's value and declining if today's value was lower. The smoothing properties of MA's are achieved at the expense of introducing lags in the data. By definition, since MA's are based on an average of past prices, turning points in MA's will always lag the corresponding transitions in the raw price series. In trending markets, MA's can provide a very simple and effective method of identifying trends and offer assistance in entering into trades.

One of the primary rules of trading is to trade with the trend, and MA's are a very effective tool in not only identifying the trend, but in also presenting entry points. Figure 5 shows that when the MA was in an uptrend, it provided buying opportunities when the market retraced to the MA. Figure 5 also illustrates the lag time when the market had a significant change in direction. The MA was slow to turn, but did provide a sell opportunity when the market rallied up to it.

Obviously, determining which MA to use can be a time and money consuming process. I have found the 21-day MA to be a very effective tool in identifying entry signals once a trend has developed, and works particularly well in the meats and currencies markets. Funds typically will use an 18-day MA for short term trades, and a 40-day MA for longer term trades. They will generally get more aggressive when the two MA's cross and are moving in the same direction.