People, myself included, sometimes
ridicule technical analysis and the charts associated with it in one breath and
then in the next reveal how much in (perhaps unconscious) thrall to these ideas
they really are. They bring to mind the old joke about the man who complains to
his doctor that his wife has for several years believed she’s a chicken. He
would have sought help sooner, he says, “but we needed the eggs.” Without
reading too much into this story except that we do sometimes seem to need the
notions of technical analysis, let me finally proceed to examine some of these
notions.
Investors naturally want to get a
broad picture of the movement of the market and of particular stocks, and for
this the simple technical notion of a moving average is helpful. When a quantity
varies over time (such as the stock price of a company, the noontime temperature
in Milwaukee, or the cost of cabbage in Kiev), one can, each day, average its
values over, say, the previous 200 days. The averages in this sequence vary and
hence the sequence is called a moving average, but the value of such a moving
average is that it doesn’t move nearly as much as the stock price itself; it
might be termed the phlegmatic average.
For illustration, consider the
three-day moving average of a company whose stock is very volatile, its closing
prices on successive days being: 8, 9, 10, 5, 6, 9. On the day the stock closed
at 10, its three-day moving average was (8 + 9 + 10)/3 or 9. On the next day,
when the stock closed at 5, its three-day moving average was (9 + 10 + 5)/3 or
8. When the stock closed at 6, its three-day moving average was (10 + 5 + 6)/3
or 7. And the next day, when it closed at 9, its three-day moving average was (5
+ 6 + 9)/3 or 6.67.
If the stock oscillates in a very
regular way and you are careful about the length of time you pick, the moving
average may barely move at all. Consider an extreme case, the twenty-day moving
average of a company whose closing stock prices oscillate with metronomic
regularity. On successive days they are: 51, 52, 53, 54, 55, 54, 53, 52, 51, 50,
49, 48, 47, 46, 45, 46, 47, 48, 49, 50, 51, 52, 53, and
so on, moving up and down around a price of 50. The twenty-day moving average on
the day marked in bold is 50 (obtained by averaging the 20 numbers up to and
including it). Likewise, the twenty-day moving average on the next day, when the
stock is at 51, is also 50. It’s the same for the next day. In fact, if the
stock price oscillates in this regular way and repeats itself every twenty days,
the twenty-day moving average is always 50.
There are variations in the definition
of moving averages (some weight recent days more heavily, others take account of
the varying volatility of the stock), but they are all designed to smooth out
the day-to-day fluctuations in a stock’s price in order to give the investor a
look at broader trends. Software and online sites allow easy comparison of the
stock’s daily movements with the slower-moving averages.
Technical analysts use the moving
average to generate buy-sell rules. The most common such rule directs you to buy
a stock when it exceeds its X-day moving average. Context determines the value
of X, which is usually 10, 50, or 200 days. Conversely, the rule directs you to
sell when the stock falls below its X-day moving average. With the regularly
oscillating stock above, the rule would not lead to any gains or losses. It
would call for you to buy the stock when it moves from 50, its moving average,
to 51, and for you to sell it when it moves from 50 to 49. In the previous
example of the three-day moving average, the rule would require that you buy the
stock at the end of the third day and sell it at the end of the fourth, leading
in this particular case to a loss.
The rule can work well when a stock
fluctuates about a long-term upward- or downward-sloping course. The rationale
for it is that trends should be followed, and that when a stock moves above its
X-day moving average, this movement signals that a bullish trend has begun.
Conversely, when a stock moves below its X-day moving average, the movement
signals a bearish trend. I reiterate that mere upward (downward) movement of the
stock is not enough to signal a buy (sell) order; a stock must move above
(below) its moving average.
Alas, had I followed any sort of
moving average rule, I would have been out of WCOM, which moved more or less
steadily downhill for almost three years, long before I lost most of my
investment in it. In fact, I never would have bought it in the first place. The
security guard mentioned in chapter 1 did, in effect, use such a rule to justify
the sale of the stocks in his pension plan.
There are a few studies, which I’ll
get to later, suggesting that a moving average rule is sometimes moderately
effective. Even so, however, there are several problems. One is that it can cost
you a lot in commissions if the stock price hovers around the moving average and
moves through it many times in both directions. Thus you have to modify the rule
so that the price must move above or below its moving average by a non-trivial
amount. You must also decide whether to buy at the end of the day the price
exceeds the moving average or at the beginning of the next day or later
still.
You can mine the voluminous
time-series data on stock prices to find the X that has given the best returns
for adhering to the X-day moving average buy-sell rule. Or you can complicate
the rule by comparing moving averages over different intervals and buying or
selling when these averages cross each other. You can even adapt the idea to day
trading by using X-minute moving averages defined in terms of the mathematical
notion of an integral. Optimal strategies can always be found after the fact.
The trick is getting something that will work in the future; everyone’s very
good at predicting the past. This brings us to the most trenchant criticism of
the moving-average strategy. If the stock market is efficient, that is, if
information about a stock is almost instantaneously incorporated into its price,
then any stock’s future moves will be determined by random external events. Its
past behavior, in particular its moving average, is irrelevant, and its future
movement is unpredictable.
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