Moving average is an important indicator. There are various type of moving average like simple moving average (SMA), Weighted Moving average (WMA), Exponential moving average (EMA) etc. Great details are available on the web regarding moving average.
If we read about moving average, we find that they confirm trend as they are laggard indicator. Moving average can be used as support, resistance. We find how to calculate moving average, types of moving average and strategy to trade with moving average. We find numerous strategies on the net regarding use of moving average. However nothing is told actually why do they work? Why common N or time is equal to 10, 20, 50, 100 or 200?
To find the answer, I searched for net but found nothing. Most people will say that N is smoothing factor. You need to find proper N for your strategy. If so, why n= 10, 20, 50, 100 and 200 are very common worldwide?
To answer the question, I made following hypothesis. Not sure, if it’s ok or there are some mistake or whether anybody have worked before. To my opinion, the answer lies in investment horizon and accounting cycle. Investors can be classified mainly short term traders, mid term traders and long term traders.
Short term traders influence:
Short term traders mainly take position for few days for example for a day to couple of weeks or at best for a month. They speculate basically on volume, momentum or recent company or sector news. They calculate their profit or loss monthly. So they are aware of monthly return which equals roughly 20 trading days. They do not like to trade those scripts which are not actively trading or price movement is not sharp. So moving average of last 10 days or 20 days actually reflects sentiment of short term traders. Although long term traders also influence daily but short term traders have more influence. So when we see price falling below moving average of 10 or 20 days, we predict that short term market sentiment is not strong.
Mid term trader’s influence: Mid term investors mainly trade quarterly basis. They calculate their profit or loss mainly quarterly basis or half yearly basis. Their buying, selling and holding decision largely depends on quarterly performance of the company, underlying technical and fundamental position. Their activity is the primary dominant factor for 50 day moving average (3 months average roughly) or 100 day moving average (roughly half yearly average).
Long term Trader’s Influence: Almost every individual or institute calculates their portfolio return yearly. They decide what to buy, sell or hold based on yearly performance. In a year, there is around 200 working days. Thus 200 day MA seems too strong.
Above all 3 type of influence 200 day MA seems too strong. They are broken quite rarely comparative to short term MA. This is because 200 MA is influence by all types of investor as short term and mid term investor’s also trade in the same time horizon.
Why moving average act as support or resistance?
Now the question comes, why MA work as support during uptrend and act as resistance during downtrend? This is again due to psychological factors of traders. When a instrument fall below MA this means, more traders are in loss or breakeven. They are panicked and try to save their equity creating sell pressure. So just after falling below MA sell pressure increase suddenly and the price fall far below MA. As soon as the price goes too far, sell pressure reduces due to reluctance to take heavy loss. As a result again price move upward and when many traders get their breakeven they start selling thus again creating sell pressure. This cycle goes on until a group or individual buys significant amount of instrument to overcome the selling pressure. Exactly opposite scenario happen during an uptrend. Whenever price touches MA most of the investors are in breakeven and they hold for getting profit. Due to reduced sell pressure price move upward until and unless majority goes for profit taking. Total psychology depends on two factor, greed and fear. In a down market, most people are afraid and in up market most people are greedy. Moving average range measures the amount of greed and fear of total market combined.
I would love to learn if anyone differ or agree with my hypothesis. Any discussion is welcome. Wish happy trading to all.