Mechanical Trading Systems: Pairing Trader Psychology with Technical Analysis

TREND-FOLLOWING INDICATORS: INDICATOR-DRIVEN TRIGGERS

Moving Averages

Simple Moving Averages and Popular Alternatives In Chapter 1 we examined two indicator-driven triggers that are also complete mechanical trading systems: the single moving average and the two moving average crossover. The variations on moving average indicators are so numerous that a book could be devoted exclusively to their various flavors; however, in the interest of completeness, I address what I believe are some of the most significant alternatives to the simple moving average.

As discussed in Chapter 1, simple moving averages are the most widely used and the easiest to calculate because they give equal weighting to each data point within the data set. This issue of equal weighting to each data point leads technicians to seek alternatives to the simple moving average.

The problem with using a moving average that gives equal weight to each data point is that with longer-term moving averages—such as the 200-day moving average—the lagging aspect of indicator means it will be slower to respond to changes in trend. Obviously slower response times to trend changes could mean less reward and greater risk. One solution to the problem of the lagging nature of the simple moving average is to give greater weight to the most recent price action. Linearly weighted and exponentially smoothed moving averages both attempt to address the equal weighting issue by giving a larger weighting factor to more recent data.²

An alternative ...