Displaced Moving Average Trading Strategy

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Moving averages are a type of charting indicator that traders use to inform price movement. Traders can sometimes make meaningful predictions about where prices are going by looking at a moving average. Many different types of moving averages exist. One of these is the "displaced moving average." For some traders, this type of moving average makes it easier to identify price trends in the stock market.

Definition

A moving average is simply an average of stock prices over time. Depending on the type of moving average, the calculation varies widely. However, the "simple" moving average calculation, which is used in the displaced moving average variant, involves a standard average formula. If you create a 10-period simple moving average, then you average together the closing prices of the previous 10 bars on your stock chart, whether they're daily price bars or any other duration. For example, if you use a five-minute chart for day-trading, a 10-period simple moving average would add the closing prices for each of the last 10 bars, or 50 minutes of trading, and then divide this sum by 10 to arrive at the average.

Appearance

A moving average is a type of technical indicator that appears directly on the stock chart. At each bar in the chart, the charting software calculates the moving average, then plots the result as a dot for that bar. This dot, which represents an average of past prices, could be at any price, even well above or below the current price. The program then connects all of these dots to create the moving average line. The slope of this line indicates if prices are rising or falling over time, on average.

Interpretation

Moving average strategies widely vary, but all involve a comparison of the current price to the current moving average line. If prices are above a moving average, then they're performing better than the average past price. Likewise, if prices fall below a moving average line, this could signal an imminent change in the stock's trend. Some traders use the moving average to signal when they should exit a stock position by holding onto the shares only when the prices stay above a moving average line.

Disadvantages

A simple moving average is a "lagging" indicator because it only incorporates past data into its calculation and doesn't accurately reflect what's actually happening in the stock currently. For this reason, some traders get "whipsawed" out of a solid trend because prices temporarily fall below a moving average before reversing and continuing the trend. A whipsaw is a temporary but significant fluctuation in stock prices that convinces many traders to liquidate their holdings. The trader has already exited the position even though more profit lies ahead. It's because of this false signal that the displaced moving average strategy was created.

Displaced Moving Average

A displaced moving average is a simple moving average that's moved forward or backward on the chart. For example, it may be moved forward by three days, such that the moving average point for the current day is the average that normally would appear for the chart bar from three days ago. Thus, the moving average ignores the most recent data, which can reduce the effect of a sudden whipsaw on exit signals.

Technique

Use the displaced moving average exactly as you would a normal moving average. In most cases, this means exiting a trade if prices fall below the moving average line. However, you may enjoy fewer false signals. Typically, traders will displace the moving average by three to five periods forward. You can experiment with different settings to find the best solution for the particular stock or market you follow.

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