The Best Moving Average: How to Calibrate it to Better Represent Market Trends
Calibrating the ideal moving average to represent the trend of an asset is essential for any trader, whether beginner or experienced. In this lesson, we’ll explore how to choose the best moving average, adjusting it according to the specific behavior of the market and the asset under analysis. Here, the goal is to be straightforward, practical, and efficient—no fluff.
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The Role of the Moving Average in Technical Analysis
The primary function of a moving average, according to Martin Pring’s classic book “Technical Analysis Explained,” is to smooth out the noise and highlight the ongoing trend. In other words, a good moving average should filter out short-term price fluctuations, helping to identify whether a price drop, for instance, is just a correction in an uptrend or the beginning of a reversal.
Imagine a common situation: the price of a stock starts to drop, and many traders interpret this as the end of the uptrend, entering short positions. However, the drop might be just a temporary correction. Here, the moving average comes into play to indicate whether the downward movement is merely noise within a larger uptrend.
Choosing and Calibrating the Moving Average
There are two main types of moving averages: the **Simple Moving Average (SMA)** and the **Exponential Moving Average (EMA)**. The choice between them depends on your trading style and the asset in question. While the SMA gives equal weight to all periods, the EMA gives more weight to recent prices, making it more responsive to changes.
To calibrate a moving average, the trader needs to adjust its period to best represent the current market trend. Let’s use JP Morgan’s stock on a one-hour chart as an example.
1. **Initial Analysis with an 8-Period SMA**: We start with an 8-period SMA. Although it represented the previous downtrend well, it was ineffective in the new uptrend, generating several false reversal signals. A fast-moving average like the 8-period SMA adjusts better in markets with strong urgency, such as a sharp downtrend, but might not be the best choice in a slower uptrend.
2. **Testing Other Moving Averages**: In search of a more appropriate moving average, we tested the 12-period SMA, but it still generated confusing signals. The 18-period SMA began to show itself as more suitable, keeping the price close and validating the trend’s continuation.
3. **Visual Adjustments**: It’s important to remember that calibration can be done visually. If you’re a manual trader, there’s no need to resort to complex backtests. Ideally, you want a moving average that respects corrective movements, meaning when the price corrects to the average and then resumes the trend.
The Importance of Closing Prices and Using Multiple Averages
A crucial point in moving average analysis is observing the closing price. Even if the price violates the average during the day, a close above it indicates that the trend may still be intact. Additionally, in situations where the trend has varying urgency, it can be beneficial to use two moving averages: a fast one, like 8 or 12 periods, and a slower one, like 16 or 20 periods.
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Practical Application and Conclusion
Let’s look at a practical example using McDonald’s stock on a one-hour chart. By adjusting the moving average to 16 periods, we observed that it better represented the trend, respecting the pullback points. However, by using two moving averages—one with 8 and another with 16 periods—we were able to better identify moments of urgency in the market.
In summary, there is no universal “best” moving average. The key lies in calibrating the moving average according to the specific behavior of the asset and the market in the period you’re analyzing. Experiment with different periods, observe corrective movements, and if necessary, use more than one average to gain a clearer view of the trend.
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What about you, which moving average do you usually use? Comment below and share your experience!
Finally, don’t forget to check out my free mini-course on international trading and investments. It’s a valuable opportunity for those looking to deepen their understanding of this world and learn how to apply these techniques in the global market. Best of luck in your trades, and see you next time!
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