TA: MA - disadvatages and strategies to tackle them

Downsides of MA

No Average is Foolproof

One of the major disadvantages of using moving averages is that they are relatively useless when an asset is trending sideways, compared to the times when a strong trend is present.

Responsiveness to Price Action

Short-term moving averages can be useful in identifying changing trends before a large move occurs, but the downside is that this technique can also lead to being whipsawed in and out of a position because these averages respond very quickly to changing prices. Because the quality of the transaction signals can vary drastically depending on the time periods used in the calculation, it is highly recommended to look at other technical indicators for confirmation of any move predicted by a moving average.

Beware of the Lag

Because moving averages are a lagging indicator, transaction signals will always occur after the price has moved enough in one direction to cause the moving average to respond. This lagging characteristic can often work against a trader and cause him or her to enter into a position at the least opportune time.

For example, the only way for a short-term moving average to cross above a long-term moving average is for the price to have recently moved higher - many traders will use this bullish crossover as a buy signal.

One major problem that often arises is that the price may have already experienced a large increase before the transaction signal is presented.As you can see in the figure above, the large price gap creates a buy signal in late August, but this signal is too late because the price has already moved up by more than 25% over the past 12 days and is becoming exhausted.

Strategies to using MA to overcome to tackle downside of MA

1) Crossovers
The most basic type of crossover is when the price of an asset moves from one side of a moving average and closes on the other. Price crossovers are used by traders to identify shifts in momentum and can be used as a basic entry or exit strategy.


The second type of crossover occurs when a short-term average crosses through a long-term average. This signal is used by traders to identify that momentum is shifting in one direction and that a strong move is likely approaching. A buy signal is generated when the short-term average crosses above the long-term average, while a sell signal is triggered by a short-term average crossing below a long-term average.


2) Triple Crossover and the Moving Average Ribbon
Additional moving averages may be added to the chart to increase the validity of the signal. Many traders will place the five-, 10-, and 20-day moving averages onto a chart and wait until the five-day average crosses up through the others ━ this is generally the primary buy sign.

Waiting for the10-day average to cross above the 20-day average is often used as confirmation, a tactic that often reduces the number of false signals. Increasing the number of moving averages, as seen in the triple crossover method, is one of the best ways to gauge the strength of a trend and the likelihood that the trend will continue.

The moving average ribbon: As you can see from the chart below, many moving averages are placed onto the same chart and are used to judge the strength of the current trend. When all the moving averages are moving in the same direction, the trend is said to be strong. Reversals are confirmed when the averages cross over and head in the opposite direction.


3) Filters
A filter is any technique used in technical analysis to increase one's confidence about a certain trade. For example, many investors may choose to wait until a security crosses above a moving average and is at least 10% above the average before placing an order. This is an attempt to make sure the crossover is valid and to reduce the number of false signals. The downside about relying on filters too much is that some of the gain is given up and it could lead to feeling like you've "missed the boat".

4) Moving Average Envelope
This strategy involves plotting two bands around a moving average, staggered by a specific percentage rate. For example, in the chart below, a 5% envelope is placed around a 25-day moving average. Traders will watch these bands to see if they act as strong areas of support or resistance. Notice how the move often reverses direction after approaching one of the levels. A price move beyond the band can signal a period of exhaustion, and traders will watch for a reversal toward the center average.


Moving Averages: Different Flavors

1) Moving Average Convergence Divergence (MACD)
It is used by traders to monitor the relationship between two moving averages. It is generally calculated by subtracting a 26-day exponential moving average from a 12-day EMA.

When the MACD has a positive value, the short-term average is located above the long-term average. As mentioned earlier, this stacking order of the averages is an indication of upward momentum. A negative value occurs when the short-term average is below the long-term average - a sign that the current momentum is in the downward direction. Many traders will also watch for a move above or below the zero line because this signals the position where the two averages are equal (crossover strategy applies here). A move above zero would be used as a buy sign, while a cross below zero can be used as a sell signal.

2) Signal/Trigger Line
Moving averages aren't limited to just stock prices; MAs can be created for any form of data that changes frequently. It is even possible to take a moving average of a technical indicator such as the MACD.

For example, a nine-period EMA of the MACD values is added to the chart in the figure below in an attempt to form transaction signals. As you can see, buy signals are generated when the value of the indicator (MACD) crosses above the signal line (dotted line), while short signals are generated from a cross below the signal line. It is important to note that regardless of the indicator being used, a move beyond a signal line is interpreted in the same manner; the only thing that varies is the number of time periods used to create it.


3) Bollinger Band
A Bollinger band technical indicator looks similar to the moving average envelope, but differs in how the outer bands are created. The bands of this indicator are generally placed two standard deviations away from a simple moving average.

In general, a move toward the upper band can often suggest that the asset is becoming overbought, while a move close to the lower band can suggest the asset is becoming oversold. Since standard deviation is used as a statistical measure of volatility, this indicator adjusts itself to market conditions. The tightening of the bands is often used by traders as an early indication that overall volatility may be about to increase and that a trader may want to wait for a sharp price move.






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ps: Content and pictures in this article are excerpted from Investopedia.