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26

UNDERSTANDING MOVING AVERAGES

A moving average is simply an average of successive numbers over a specified time period which is constantly updated by dropping the oldest number in the succession, a dding the newest number, and then retotalling and reaveraging.

For example, to obtain the 10-day moving average of the daily closing of the Dow Jones Industrials, you start by summing and averaging 10 consecutive days. On the eleventh day, you add that clo sing number to the previous 10-day sum. then subtract the first day, and divide by 10 to get the updated average. By continuing this process on a daily basis, the average "moves" from day to day: that is. it changes in a way that takes into account the latest closing price. If you plot the daily results and superimpose it over the plot of day to day prices, the result looks like Figure 8.1.

Whats the point of doing this? Moving averages tend to smooth out erratic fluctuations in market price movements, and they are useful in determining trends and trend reversals. Because they are averages over a specified period of time, they are. by definition, dampened indices which lag behind more immediate price fluctuations. The longer the averaging period you use, the greater is the dampening, or lag. effect. By studying various moving averages, it is possible to identify certain

Daily Bar Chart

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TQ 20/20 91991 CQG Inc.

Figure 8.1 The Dow Jones Industrials daily bar chart-the 10-day moving average. The solid line is the 10-day moving average for the closing prices of the Dow Industrials. Note that the moving average line lags and dampens the movement of actual prices.



repeating pattems which can be used to determine the probable course of the price trend. Some of the pattems are so well-defined that they can be used as buy or sell signals in both stocks and commodities.

Virtually every stock chart book that I have ever seen uses some type of moving average. Many individual technicians and traders use their own moving average formulations, weighting the near weeks or using exponentials in their calculations. But rather than discuss the variety and type available, let me simply tell you which ones I use and how I use them.

As far as Im concemed, in the equities markets (individual stocks and stock indexes), by far the most useful of all the moving averages Ive seen is the 200-day (thats 200-trading day or 40-week) moving average (see Figure 8.2).

1 keyed into this in 1968 when I read the results of a study by William Gordon demonstrating that by buying and selling the Dow Jones Industrials stocks from 1917 to 1967 using only the 200-day moving average, an investor could have realized an average yearly simple retum of 18.5%. By comparison, his study showed that Dow Theory would have realized 18.1% per year if an investor bought and sold on confirmation days of bull and bear markets. In the study, Gordon used two simple mles to det ermine buy and sell signals from the moving average:

Dow Jones Industrials Daily Bar Chart

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200 Day Moving Average Line

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TQ 20/20 ? 1991 CQG Inc.

Figure 8.2 The Dow Industrials with two hundred-day moving average.

1. If the 200-day moving average line flattens out following a previous decline or is advancing, and prices penetrate the moving average line on the upside, this comprises a major buying signal (see Figure 8.3).

2. If the 200-day moving average line flattens out following a previous rise or is declining, and prices penetrate the moving average line on the downside, this comprises a major selling signal (see Figure 8.4 ).=

You can use the long-term moving average as a predictor not only for the averages, but also on



individual stocks and most commodity futures. 1 personally use it for two basic purposes-to confirm Dow Theory in determining the course of the long-term trend and in making specific stock selections.

When picking stocks, I never buy a stock when prices are be low the moving average, and I never sell a stock when the price is above the moving average. Just pick up any chart book that uses a 35- or 40-week moving average and youll see why-the odds of being right are way against you.

As far as using other, shorter-term, moving averages. I have only found one other set of observation that works consistently and stands the test of time. This works not only for stocks and stock indexes, but for many commodities as well.

1. When the 10-week moving average crosses the 30-week moving average and the slope of both averages is up, this comprises a buy signal, provided that prices are above both moving average lines (see Figure 8.5).

dow lones tnciustrials daily bar cthart

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tq 20/20 e 1991 cc?g inc.

Figure 8.3 The Dow Industrials, with the two hundred-day moving average for-a buy signal. If the 200-day moving average line flattens out following a previous decline, or is advancing, and prices penetrate the moving average line on the upside, this comprises a major buying signal.

dow jones industrials daily bar chart

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tq 20/20 s 199 1 cqg inc.

Figure 8.4 The Dow Industrials with the two-hundred-day moving average - a sell signal. If the 200-day moving average line flatterns out following a previous rise, or is declining, and prices penetrate the moving average line on the downside, this comprises a major selling signal.



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