When traders and investors study technical analysis, one of the first indicators they learn about are moving averages. It feels good to build a trading system based on moving averages because they are easy to calculate and, most importantly, they are straight-forward to apply.
Most people have an employee mentality. They want to know exactly what they have to do to make money. They are psychologically happy with the idea of a job description and a steady paycheck. Moving average systems seem seductive because all you have to do is buy when the current price (or a shorter moving average) crosses above the moving average, and sell if the price (or shorter average) crosses below the moving average. It’s clean – no ambiguities.
The problem, of course, is that markets are not well behaved. Trading is not a predictable job with steady results.
In the case of moving averages, you can make money when the markets are trending.
But, as soon as the markets become choppy (and don’t trend up or down), the moving average system will get whipsawed. This means that the trader will start to take losses by buying high and selling low. Over time, the winning trades and losing trades cancel each other out.
Is there a way to fix moving average trading systems, so that they avoid choppy markets?
One idea would to only recalculate an X day moving average when a new Y day high or low occurs.
For example, you might use a 20 day moving average, but then only recalculate it when a new 50 day high or low occurs.
During a trend, new high or lows occur frequently, so the moving average will be updated faster. In a choppy market, the moving average will not be updated as frequently, so it might give the market more room to breathe – thus generating less false signals.
Just remember that this is an idea, and not a complete trading system. Every trader needs to develop their own system, to suit their personality.
The trick to trading successfully is to find a classic method that appeals to you, learn its strengths and weaknesses, and add your own twist to improve it.