Moving averages, commonly referred to as MAs, are the average stock prices over a specific period. Investors often use various MAs such as the 5-day, 20-day, 60-day, 120-day, and 240-day MAs. However, just how reliable are these moving averages?
The Meaning and Limitations of Moving Averages
A moving average is simply a numerical value representing the average stock price over a certain period. For example, a 5-day MA averages the stock prices over the last 5 days, while a 1-minute 3-MA averages the price every 3 minutes. New investors might mistakenly believe the numbers on a stock chart represent something significant, but they are simply 'round numbers' with no intrinsic meaning.
Psychological Effects of Numbers
People have a tendency to favor numbers that fit neatly into the decimal system. This preference extends to stock trading, where investors use MAs like the 5-day, 20-day, 60-day, 120-day, and 240-day MAs. This is similar to how certain currency notes with special serial numbers are highly valued or how milestones in sports are celebrated. However, in reality, these numbers hold no real significance.
Claims of Stock Experts and Doubts
Some stock experts claim that the 20-day MA reflects the stock's performance over a month, and the 60-day MA is linked to the quarterly earnings cycles of companies. They also assert that the 120-day MA can forecast economic conditions and future corporate performance. However, these claims are questionable.
Reflecting Stock Performance through MAs
Does the 20-day MA truly represent a month's worth of stock performance? The stock market only operates on weekdays, so a 'month' can span 20 to 22 trading days, or even fewer during holidays. Thus, the idea that the 20-day MA reflects a full month's stock performance is flawed.
Similarly, companies release their quarterly earnings every three months, making the 60-day MA supposedly reflective of this period. However, the stock market's three-month span can range from 60 to 66 trading days. For example, if someone needs to fill a 60-liter tank using a 10-liter bucket, they must make six trips. But if they incorrectly believe five trips are enough, it reveals a fundamental misunderstanding of the process.
Using Various MAs and the Issues
Some suggest that short-term investors consider the 60-MA on a 1-minute chart and the 20-MA on a 3-minute chart as equivalent since both cover the same total time. However, while the total time may be the same, the unit composition is different, leading to different MA values.
Weekly and Monthly MAs
Experts advise looking at weekly 5-MAs and 4-week or 5-week MAs, suggesting these reflect a month's trading activity. However, this doesn't hold up when considering daily trading sessions. A 5-day MA calculated on a Friday reflects the entire week's trading, but one calculated on a Monday doesn't. Similarly, the concept that a 4-week or 5-week MA captures a full month's trading cycle is misleading.
Conclusion
MAs can provide psychological comfort to investors, but they do not accurately reflect stock price movements. Rather than relying solely on MAs for trading decisions, it's essential to use them as reference points for understanding market trends. Remember, MAs are just numbers; establishing a more objective trading strategy is crucial.
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