How Can We Know When Is The Market Trending Upwards?
Almost nothing is certain in investing. Our best bet at winning is simply putting the odds of success in our favour. There will be times when we make a rational decision which turns out to be wrong and there will be times when we make an irrational decision which turns out to be right. The central feature of markets is that they’re volatile by nature. This is where Technical Analysis (TA) comes into play. We use TA indicators to leverage on existing data to make more informed decision that has a higher likelihood in leading to our desired outcomes.
We’ll be focusing on Simple Moving Average (SMA) today.
We’ll begin with the boring theory followed by the arguably exciting application next. The SMA takes data from a set period of time and produces the average price of that asset. To calculate an SMA, you take the sum of the closing prices over a given period of days, then divide it by the number of days in that period. For example, if it is for a 10-day SMA, you simply take the sum of the closing price data over the last 10 days then divide by 10. If your SMA is based on a short time frame, it will be more volatile but it will closely follow the source data. If you base your SMA on a long time frame, there will be a smoother moving average. Before you go cray (or ham or whatever it is that kids are using nowadays), you don’t actually need to do this manually. Similar to the RSI Indicator, just go to any price chart comparison sites such as TradingView, key in the stock that you’re keen in, look for “Indicators” on the top, type Moving Average and click it.
It’ll take you less than a minute to have a general overview of the asset’s momentum.
You’ll soon notice that you can actually adjust the period setting. If you wanna look at a 10-day / 50-day / 200-day SMA, you can do so. So the next question is: “What is the best period setting?” It depends on your gameplay. If you’re going for short-term day trading, you probably need a moving average that is fast and reacts to price changes immediately. You’ll hover between 10 to 20. If you want even more immediate reaction, you may prefer using EMA (Exponential Moving Average) over SMA (Simple Moving Average). Do note that while EMA reacts faster when the price is changing direction, it also means that it is more vulnerable in giving the wrong signals too early. If you’re going for a century-long time horizon, you’re probably hover between 50 to 200. Essentially, you want to plot 2 or more lines (E.g. 50-MA and 200-MA) and see at which point is the cross over.
A rising MA is indicative of an upward trend and a falling MA indicates a downtrend.
The question that we’ve all been waiting for: “How can we know when to buy with the usage of moving averages?” If both your 50-MA and 200-MA are falling and you wake up to find that the 50-MA is gradually crossing over 200-MA, it may just be a bullish crossover signal. If both your 50-MA and 200-MA are on an upward trend and you wake up to find that the 200-MA is gradually crossing over the 50-MA, it may just be a bearish crossover signal. I sincerely believe there is no gold standard for which exact period setting you use. Even though we’re buying the same asset, reading the same news and looking at the same market prices, we have wildly different goals and risk tolerances. Ideally, 50-MA over 200-MA over a timeframe of 10 years is the best given that it is the period in which markets are nearly always to reward your patience.
“That’s nice, but can we have it faster?” is probably what will ruin us.
We have to bear in mind that optimism always overshoots. We take a humble look at an uptrend and we immediately want to jump into the price action. The thing is all asset prices rely on subjective assumptions about the future. If you’re dipping your toes into investing and technical analysis, you’ll find that a lot of peaks in market cycles always look irrational in hindsight. It is obvious it became overpriced and went too far. But when you’re experiencing an uptrend in real time, you’ll always feel like there are opportunities left for you to exploit.
Good times tend to breed complacency and skepticism of warnings.
As Daniel Kahneman wraps it nicely, we all need to have a well-calibrated sense of our future regret. This way, we can survive an undesired outcome financially without getting forced out and also pull through mentally without being scared out. One thing we need to remember is that bad decisions occur when we can only accept one version of our future. Combining various technical indicators such as RSI and MA together may increase our odds, but it doesn’t mean that we will definitely win. At the end of the day, investing can simply be about pulling through a 40% crash in 3 months or the worst case scenario of a 100% crash in 5 years. Yes, the chances are slim, but if it happens, can you handle it financially and emotionally?
