CHARTING - BEST PRACTICES
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HOW WE USE MOVING AVERAGES



The stock market used to be a far more slow-moving machine than it is in today's fast-paced, computer-driven times. Because trading was much slower before the 1970s (trades occurred, on average, only about once a year), if investors used charts at all, they were used with monthly or (rarely) with weekly settings.

The 20, 50, and 200-period averages were applied initially to weekly charts. Most considered the 20-week moving average to be an intermediate-term measure that encompassed five months, while the 50-week moving average was a long-term measure of the status of prices.

SIGNIFICANCE OF 50-WEEK EMA

The 50-week moving average represents one year of price action because there are 50 weeks in a 'market year' (i.e., 52 weeks in a calendar year and the NYSE and other exchanges usually have ten days off for holidays = 50 weeks). Investors sometimes used the 200-week moving average as a very-long-term measure that represented four years of stock-price action.

When the baby boom generation started their careers and began saving for retirement in the late 1970s, millions of stockbrokers were added to the workforce to handle all those new investors. The trading of stocks started to occur more rapidly in the late 1970s and 1980s as aggressive baby boomer stockbrokers pushed the boundaries of old traditions, often coming up with more aggressive, more frequent trading ideas that generated more commissions for themselves and their companies. 

DERIVATION OF MODERN SETTINGS?

Many modern investors often wonder about the numerical significance of the 50-day and 200-day moving averages. Alas, laziness may have led to 1970-1980s chartists merely borrowing from these proven weekly settings for their parameters as the pace of trading increased and chartists began using daily charts.

It appears that the established technical-analysis moving-average settings used with weekly and monthly charts from the days of slower trading were simply borrowed and applied to daily charts, without a change. If you think about it, it makes sense to use a 50-week moving average to represent a year – but 50-days, used with the ubiquitous 50-day moving average that is a default on every chart we see published on the internet, really is quite arbitrary. What exactly is the significance of 2.5 months (50 days)? Unknown...

Of course, technical indicators are 'scalable' in that an indicator that works on a monthly chart will almost always also work on a weekly chart, a daily chart, or a five-minute chart, etc. For example, we can apply moving averages, MACD, Stochastics, RSI, etc. on virtually any chart timeframe and generally, it is still a useful indicator.

So, the 50-day and 200-day moving averages, perhaps borrowed out of sheer laziness and lack of a creative spark, became well-known and widely used as daily charts became generally accepted for the faster-paced trading that began in the 1980s.

However, because so many investors use them and they are presented as standard fare on virtually every published chart on the internet, 50-day and 200-day MAs may have become a self-fulfilling prophecy. By that we mean that if millions of investors are using a rule of thumb that says to sell stocks or avoid buying when the S&P 500 price drops below the 200-day moving average, then it will become apparent that the 200-day moving average is now a significant threshold - i.e., a self-fulfilling prophesy because of the sheer number of users.

RECOMMENDED CHART SETTINGS

Keep in mind that the shorter the time segment you observe on a chart, the more likely it is you will see a lot of meaningless noise that can lead you astray.

ETFOptimize recommends that for those subscribers wanting to track the prices of the ETFs in your strategy(s), you should use weekly charts to minimize noise, and apply 20-week and 50-week averages as the intermediate-term mean and the long-term mean of those ETFs.

Those means almost always draw prices to them, and when exuberance or fear stretches share prices too far in one direction or the other, there is inevitably a reversion-to-the-mean that brings them back to 'earth.'

By being aware of overextended conditions, investors can be prepared for the inevitable reversion-to-the-mean, correction moves. Just remember, as long as underlying, fundamental conditions remain intact, corrections are merely technical price adjustments and have little significance.

 

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