Investing Perception vs Reality: Moving Average

Online Trading Academy Article of the Week

by Sam Seiden, Online Trading Academy

Drawing consistent low risk profits from trading and investing is a challenge many millions of people take on, yet only a select few are ever able to attain.

The objective and mechanical rules for consistent low risk profits are very simple, yet the layers of illusions keep most from ever seeing what is real in trading and investing. The two main forms of analysis in trading and investing are technical and fundamental analysis, and they are very real. However, thinking that mastering these two forms of analysis will lead to consistent low risk profits is an illusion second to none. The more an individual attempts to master these types of analysis, the more they may be layering subjective complex illusions on top of each other. This is a recipe for never achieving your financial goals.

What many beginning traders and investors don’t realize is that they are walking east and west trying to reach the North Pole. No matter how hard they work, the goal they desire is not attainable as the path they are on is an illusion. Trading strategies that work don’t change with time or changing market conditions. Quite frankly, to think market conditions ever change at all is a strong illusion that can only be removed when one focuses on the foundation of price movement: supply and demand. A simple and minor shift in perception to what is real can lead to a monumental shift in trading and investing performance.

The focus of this piece is to identify and remove the veil of illusion from trading and investing. How? By realizing that the movement of price in any market is based at its core on an ongoing supply/demand and human behavior relationship, and understanding that low risk / high reward opportunity exists when this simple and straight forward relationship is out of balance. First, I will quantify a supply/demand imbalance for objective opportunity. As most traders and investors are well aware, the overall goal is to decrease risk and increase profit potential. However, many strategies actually accomplish the opposite. Results for everyone from the active trader to the casual investor follow from taking various actions. Instead of focusing on changing our actions, it’s time to notice where those actions come from: illusions. The strongest illusions in the trading and investing world are found at the core of fundamental and technical analysis. Within these two forms of analysis lie many levels of illusion. In this piece, I will focus on indicators, specifically the Moving Average.

Dow Daily Chart – 10/15/15

Moving Averages

The Illusion:

This is a daily chart of the Dow. The information most people will perceive from this chart is an illusion that will likely lead to high risk/low reward trading and investing. The illusion here is that moving averages (MA) somehow act as demand or supply (market turning points). There are many conventional ways in which some people use moving averages. These include using moving average crosses for entries and exits, measuring the slope of a MA for a “trend filter,” or using a MA as demand or supply. However, the notion that MA’s actually offer a benefit when used in these conventional ways is completely false. It is an illusion.

In the chart, a 20- and 200-period moving average are shown (Blue and Red line). These are widely used moving averages both in the trading and investing community. Notice the slope of the 20-period MA at the areas labeled “B.” The slope of the 20-period moving average is down in both cases suggesting a downtrend is underway. During this period however, the low risk/high reward buying opportunity is greatest and right in front of you!

Those who use a MA as a trend filter would never buy when the trend is “down.” This group of illusion-based traders and investors would likely conclude and say:

“I don’t want to buy now, the MA tells me this is a downtrend.”

The illusion created by using a MA to determine trend ensures you will ignore the lowest risk/highest reward opportunity each time it is offered. Furthermore, this illusion is likely to encourage a trader/investor to take the opposite action of what the objective information (reality) suggests he or she should do.

Moving Averages Lag

MA’s are averages of past data. They can only turn higher after price does. Let’s focus in on the 200-day moving average. Specifically, notice the areas “B” that are below the 200-day MA in the chart. Most traders and investors either see the 200-day MA on a chart or hear about it from some financial news TV program. They perceive the mighty 200-day MA as some magical line that when crossed suggests some valuable information. As we can see, waiting for prices to rise above the 200-day MA before buying ensures three things. First, risk to buy is high as one would be buying far from the supply/demand imbalance. Second, profit potential is decreased. Third, those who wait until prices have crossed back above the 200-day MA to buy will provide profit for the reality based trader/investor who bought at “B,” the low risk/high reward entry area. The objective supply/demand imbalance is at “B” and the 200-day MA has nothing to do with it. When a moving average lines up with true demand or supply, the moving average will appear to work. Believing that the moving average actually has anything to do with a turn in price is an illusion.

The Reality:

Let’s now explore reality through the eyes of objective logic. The area labeled “A” is objective demand (support) on the daily chart. How can I claim it is objective demand? Simple, while prices are trading sideways supply and demand appear to be in balance. Prices rose dramatically from that area of perceived balance. The only thing that can cause a price rally from that area is when the supply and demand equation becomes “out of balance.” In other words, there was much more willing demand at “A” than willing supply. The laws of supply and demand simply tell us this is true.

Let’s now explore reality through the eyes of objective logic. The area labeled “A” is objective demand (support) on the daily chart. How can I claim it is objective demand? Simple, while prices are trading sideways supply and demand appear to be in balance. Prices rose dramatically from that area of perceived balance. The only thing that can cause a price rally from that area is when the supply and demand equation becomes “out of balance.” In other words, there was much more willing demand at “A” than willing supply. The laws of supply and demand simply tell us this is true.

The areas labeled “B” represent the first time prices revisit this area of “imbalance.” In other words, price has declined to an area where there is more willing demand than supply. “B” is the low risk/high reward opportunity to buy, or where we expect price to turn higher. Buying in this area ensures three important musts in trading and investing. First, your protective stop must be as small as it can be which offers a trader proper risk management/position sizing (low risk). Second, your profit potential, which is the distance from the entry to the supply area above, is as large as it will ever be for this opportunity (profit zone). In other words, as price moves higher from the objective demand level it is moving closer to the supply level, (target) above, decreasing your profit potential. Third, the probability of success is highest because supply and demand are out of balance at that level.

The Lesson: Indicators and oscillators are nothing more than a derivative of price and volume. Price is all that needs be considered when performing objective, reality-based analysis if you desire true low risk, high reward, and high probability trading and investing.

A successful trader’s path must be reality based, not driven by illusion. The reality is that markets are nothing more than pure supply and demand at work; human beings reacting to the ongoing supply/demand relationship within a given market. This alone ultimately determines price. This piece is meant to help offer everyone a more complete perspective on how the markets really work.

Hope this was helpful. Have a great day.