by Helmut Schmidhofer
The ancient and proven method of trendline analysis is a profitable but manual operation. Trendlines are drawn by eye. People, even traders, are lazy and want menial tasks to be automated.
Many years ago, statisticians discovered that a simple moving average closely resembles a trendline. Bingo, we can now make a machine to trade for us. If you compare the MA3 line in the above diagram with the trendlines, you can see a good resemblance.
The same rules apply - a change in trend is signalled when prices break through the MA-line. One must not be too eager to call a new trend, therefore, some slippage will invariably occur.
In the good old days, you would draw a trend channel based on linear regression. You would look whether prices were close to the channel top (likely to go down) or channel bottom (likely to go up).
Well, no more. A moving average of a longer time frame (usually 3 to 4 times the base MA) serves as a long-term trend indicator, signalled by a crossing of the long term by the short term in the direction of the trend, as the graph illustrates.
As you would expect, automated trading based on moving averages alone is subject to two problems - (i) if the signal is too tight, the number of whipsaw losses increases; and (ii) if the signal is too wide, excessive slippage will erode the potential profit.
If you trade manually, I see no benefit that moving averages could have over personal trendlines and SCHM bands.
You will note that the end of the graph gives a hint of a long-term trend change, which is too
early to call. The sell signal contradicts two of the three possibilities considered with SCHM.
Crossings like this, where the data down-crosses the minor and the minor down-crosses the major
all at the same time, might persuade an eager trader to go short. If enough people see the signal
(millions are watching moving averages), it could become a self-fulfilling prophesy.
This in turn would trigger numerous stops, accelerating the process. Professionals who must square their order book add to the mayhem.
Before you know it, you have a panic on your hands, all because three little squiggly lines crossed in the same direction on the same day. Such is the power of moving averages.
Therefore, even if you don't trade with moving averages, you MUST keep your eye on them. They are used by too many people, to be ignored.
So popular have moving averages become that countless variations have sprung up - weighted averages, leading averages, exponential averages, and many more, plus centered harmonic means, which are the core of SCHM bands.
Some of these variations are discussed in the next chapter.
Back to SCHM bands Proceed to other averages
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