Trading Basics: Evolution of a Trader

STOPPED BY A MOVING AVERAGE

A moving average is an average of numbers that is said to move as the most recent price quote is added and the oldest quote is dropped from the sequence. For example, if price has the following closing values, 10, 11, 12, and 13, the average is (10 + 11 + 12 + 13) ÷ 4 or 11.50. Four is a count of the number of price quotes used. If we averaged five numbers then we would divide the total by five instead of four.

Say another closing price comes in and it is 14. The moving average would be (11 + 12 + 13 + 14) ÷ 4 or 12.50. We drop 10 since it is the oldest and add 14, dividing by four. This would represent a 4-day or 4-period simple moving average.

If you were to plot the moving average on a chart, it would hug price as it waves up and down. The higher the number of days used in a moving average calculation, such as a 200-day moving average, the flatter the line appears and the more lag (delay) is introduced. Lag means it takes longer for changes in price to reflect in the moving average. Short moving averages look choppy and hug price closer with little lag.

Stan Weinstein recommends using a 30-week simple moving average for long term investing. I discuss his implementation in detail under in the “Using Trailing Stops to Sell” section in Fundamental Analysis and Position Trading, Chapter 16. Briefly, when price makes a minor low and then recovers, place a stop directly below the date of the minor low at a price slightly below the moving average.

The coming ...