by: Jim Wyckoff
Those who have followed my work for some time know that I take
a “toolbox” approach to analyzing and trading markets. The more
technical and analytical tools I have in my trading toolbox at my
disposal, the better my chances for success in trading. One of my
favorite "secondary" trading tools is moving averages.
In a past educational feature, I explained how I use my two
favorite moving averages: the 9- and 18-period moving averages.
In this feature, I will discuss using three moving averages in
analyzing and trading a market. It's called the "triple-moving
average" method.
The moving average is one of the most commonly used technical
tools. In a simple moving average, the mathematical median of
the underlying price is calculated over an observation period.
Prices (usually closing prices) over this period are added and then
divided by the total number of time periods. Every day of the
observation period is given the same weighting in simple moving
averages. Some moving averages give greater weight to more
recent prices in the observation period. These are called
exponential or weighted moving averages.
The length of time (the number of bars) calculated in a moving
average is very important. Moving averages with shorter time
periods normally fluctuate and are likely to give more trading
signals. Slower moving averages use longer time periods and
display a smoother moving average. The slower averages,
however, may be too slow to enable you to establish a long or
short position effectively. Moving averages follow the trend while
smoothing the price movement. The simple moving average is
most commonly combined with other simple moving averages to
indicate buy and sell signals.
In the triple-moving-average method, "period" lengths typically
consist of short, intermediate, and long-term moving averages. A
commonly used system in futures trading is 4-, 9-, and 18period
moving averages. Keep in mind a time "period" may be minutes,
days, weeks, or even months. Typically, moving averages are
used in the shorter time periods, and not on the longer-term
weekly and monthly bar charts.
The trading signals generated by a triple moving average may be
interpreted as follows: The shorter-term moving average above
the longer-term average indicates a bullish market. When the
shorter-term moving average crosses below the longer-term
moving average, the market is viewed as bearish and a sell signal
is generated. If the shorter-term moving average remains below
the longer-term moving average, the market is still considered
bearish. When the shorter-term average crosses above the
longer-term average, a possible reversal to a bearish market is
signaled.
The relation of the three moving averages can help to better and
more quickly define the strength of the trend and provide shorter-
term trading clues. For example, if the 4-period moving average
crosses above the 9-period average, but the 9-period is still below
the 18-period, that signals a trend change may be on the horizon,
but it's best to wait for the 9-period to cross above the 18period
for a better reading of the trend change.
The trader who uses shorter timeframes to trade markets is better
suited to using the triple-moving-average method--because
trading signals are given faster. But keep in mind the shorter the
moving average, the greater the potential for false signals.
Here is an important caveat about using moving averages when
trading futures markets: They do not work well in choppy or non-
trending markets. One can develop a severe case of whiplash
using moving averages in choppy, sideways markets. Conversely,
in trending markets, moving averages can work very well.
When looking at a daily bar chart, one can plot different moving
averages (provided you have the proper charting software) and
immediately see if they have worked well at providing buy and sell
signals during the past few months of price history on the chart.
As an aside, veteran ag market watchers say the "commodity
funds" (the big trading funds that many times seem to dominate
futures market trading) follow the 40-day moving average very
closely when they trade the grains. Thus, if you see a grain
market that is getting ready to cross above or below the 40-day
moving average, it just may be that the funds could become more
active.
