The determination of whether prices are trending or trading is an important one in choosing the appropriate technical indicators.
When prices trend they move strongly in one direction, this was the pattern the TASI experienced at the end of 2003 until the crash that took place by the end of February 2006, prices kept moving upward in a major bull run.
Trading prices on the other hand would be prices moving sideways in a back and forth pattern, this is the pattern we see these days in the TASI.
A popular market indicator used in trending markets is the moving average.
A moving average is the average price of a security at a given time.
The time span depends on the choice of the market trend that is to be identified: short, intermediate or primary.
If you are an investor the appropriate time span to use would be the 200-days. A speculator would use a shorter time span ranging from 25-days to less than 200-days.
And finally a trader focusing on short-term fluctuations may use an average ranging from 10-days to less than 25-days.
After the appropriate time span has been chosen the moving average is calculated by adding the closing prices of a security for the number of periods and then dividing the total by the number of time periods.
The mathematical formula for this would be:
n
_ = closing price
1 n
where n is the number of the time period, for instance 200 if you are working with a 200-day moving average.
The above calculation is used for the simple moving average, there are different types of moving averages, the significant difference between them is the weight assigned to the most recent data.
A simple moving average as the one calculated above applies equal weight to all the prices, exponential and weighted moving averages apply more weight to recent prices, variable moving averages change the weight according to the volatility of prices, triangular moving average apply more weight to price in the middle of the time period, and finally volume-adjusted moving averages change the weight according to the volume associated with each price.
A moving average tends to smooth down price fluctuations this makes it possible to identify certain patterns which can be used to determine the probable course of the price trend.
After the moving average is calculated, it is plotted on the chart along the price of the security.
The most popular term of interpretation for a moving average is the comparison of the moving average of a security with the price of its security.
A buy signal is generated when the securities price rises above the moving average, and a sell signal is generated when the securities price falls below its moving average.
Moving averages are not intended to get you in at the exact bottom or out at the exact top, they are designed to keep you in line with the securities price trend by buying shortly after the securities price bottoms and selling after it tops, this is why they are called lagging indicators or trend following indicators.
Trend following indicators always have you buy and sell late but in exchange for missing in early opportunities, they greatly reduce your risk by keeping you on the right side of the market.
The best way the moving average indicator has worked for me is by focusing on the All Tadawul Saudi Index’s moving average as well as the moving average for the security chosen, I rarely buy a security if the TASI is below its moving average.
