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Chapter 9. The most valuable technical t... > How many days should you use in your...

How many days should you use in your moving average?

The length of the moving average has a great impact on trading activity and, therefore, profitability. Some traders use 5-day moving averages, whereas some use 10-day or 20-day, and many funds use 50, and so on. For longer-term traders, particularly stock market investors, the 100- and 200-day moving averages are popular. The length is an arbitrary decision that depends on the type of trader, but the sensitivity of any moving average is determined directly by its length. The length determines how much time a moving average has to respond to a change in price. It is a matter of “lag time.” This is a simple, but important concept—shorter moving averages are more sensitive than longer moving averages. A 5-day is more sensitive than a 10-day, and both of these are more sensitive than a 20-day. The more sensitive the moving average, the smaller the loss will be on a reversal signal; however, there also will be a higher likelihood of a whipsaw, where a false reversal signal causes a trader to reverse a trade too soon.

A false signal occurs when a minor movement, which ultimately does not change the major trend, is enough to push the moving averages in the opposite direction of the settlement price, therefore resulting in a false position change. It is false simply because the trader will subsequently need to reverse once again when the major trend reasserts itself. In other words, it's important to use a moving average that is long enough so it is not overly sensitive. On the other hand, if the moving average is too long, the trader tends to take too big a loss (or give up too big a portion of unrealized paper profits) before he is even aware of a trend change. A longer moving average keeps you in a trade longer, thereby maximizing paper profits, but it can eat into realized profits because it moves too slowly. So just like the story of the three bears, the moving average cannot be too hot or too cold; it needs to be “just right.” I receive more questions about what is the “right” moving average to use than any other. I discuss the right moving average to use (in my opinion) in greater length in Chapter 10, “How I use 'TMVTT,'” but the bottom line of “just right” is not always that easy to determine and changes with market conditions. Voluminous studies have been done to determine which length is right for which specific market, but I believe these are useless simply because market conditions change for any and all markets. The silver market of the Hunt era is not the same silver market of today. Soybeans in a drought market act far differently from a normal weather market. In the next chapter, I will share just which moving averages I use and how I use them, but first it's important to discuss varieties other than the SMA.


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