New Techniques  |  JAN 2000

More Responsive Moving Averages by Joe Sharp,Ph.D.

More Responsive Moving Averages by Joe Sharp,Ph.D. Traders are resigned to moving averages being behind the price action,but that needn’t always be the case. Here’s an algebraic technique to make your averages more responsive to price movement - and a better aid in decision--making. Moving averages serve two main purposes: to show the underlying security value after noise has been filtered out and, implicitly, to delay decisions to reduce whipsaws. However, that delay frustrates traders who must make decisions based on what is happening right then and there. You can fix that. I’ll show you a corrected moving average that can follow trends accurately. You’ll have to endure a little math to get the idea,or you can use the spreadsheet I’ve provided in Sidebar 1. THE OLD WAY First,I want to show you a simple example of a problem that’s easy to calculate by hand. It can be seen in the spreadsheet in Figure 1, and I’m using it here just to introduce the problem and suggest how to fix it. Start the column marked ""Day"" at day zero and run it downward to 19. Then,starting at day 1, give the security value column values from one up to 10 and back down to one. Compute a simple two-day moving average by hand. The first value, for example, in column C is (1+0)/2 =0.5. On day 2, it’s (2+1)/2 =1.5, and so on. The Error column is the difference between the security’s price and the average. For the first line, that’s 1 -0.5 =0.5. The column shows that the average will never be able to catch up with the rising and falling ramp; it will always lag behind the correct value of the underlying security by half the change in the period included in the average. Similarly, simple moving averages lag behind falling security values.

by Joe Sharp, Ph.D.