More on moving averages and a lesser known indicator for stockmarket traders

By: Mike Estrey
Finding a suitable indicator that reliably defines a trend is one of the keys to successful investing, whether it is on the stockmarket, in forex trading or commodities. CFD traders are often faced with a bewildering array of trend indicators on their software, and when searching for the elusive holy grail of the perfect indicator, the idea is not to miss a major move but also not being whipsawed too often. There is of course no straightforward indicator, but this paper looks at the less well known TEMA.

The basic moving average

Traders usually begin with a basic simple moving average, which is easy to plot, and here there is a trade off in terms of the amount of data used. Longer term investors tend to begin with the 200 day moving average which is something of a yardstick, and the trend rules are very simple. If the share price is above the 200 dma, and the average itself is rising, this suggests a long term bullish trend or a buy signal. The opposite scenario is often used for selling, and long positions are often closed out if one of the above conditions is breached, but each investor has there own methodology.

The obvious problem here is that such a long term indicator misses the first few months of a change in trend, and whilst this is not such a problem for very long term players, it can result in the giving back of a large chunk of profits at the end of a trend. The benefits though are that very few changes need to be made to a portfolio, and there is a much lower chance of a quick reversal in the trend, which can often last many years.

As the length of a moving average shortens, more signals are giving as the average responds quicker to trend changes, but there is also more whipsaw action. In trading range markets, which can often last far longer than trending conditions, moving averages are of little use.

A quick word on the MACD

One refinement to standard moving average analysis is to use crossovers as signals, and one formula derived from this is the MACD which can be used to identify turning points, the momentum and the trend of any stock or index. The most popular MACD formula starts by subtracting the 26 day exponential moving average from the 12 day exponential moving average.

Crossovers between the moving averages are often used to provide golden and dead cross signals, and that formula provides the basic MACD line and the initial signals to watch for. What then happens is that a 9-day exponential moving average of that line is taken, and this is called the signal line, which gives various useful signals.

MACD has become very popular in recent years, and because of this there are now many false breaks and chaotic action which make its success rate questionable at the very least.

There is though another smoothing indicator which has been tested by some technical analysts to give more precise trend change recommendations. Again it works better in trending markets, but it has uses in spotting turning points, and some analysis suggests that it is better than the MACD as an all round indicator.

TEMA - Triple exponential moving average

TEMA is not that old and was developed by Patrick Mulloy in the early 1990s.
His idea was to try and reduce the time (and profit) lag in moving averages as the moving average length increased, and his solution was a modified version of exponential smoothing but with less lagging.

TEMA is not simply a moving average of a moving average of a moving average, but it is a composite indicator using a single exponential moving average, a double exponential moving average, and a triple exponential moving average. As with any moving average based technique, the trader can use opening, closing, high or low prices, but usually closing process are chosen.

The TEMA formula

1 Establish a simple (exponential is better though) moving average (EMA1)

2 Calculate a double exponential (EMA2).

3 Calculate a triple exponential (EMA3).

4 TEMA equals: (three times (EMA1 minus EMA2) ) plus EMA3

As with all moving average based analysis, the longer the timeframe used, the less responsive the TEMA will be to trend changes, but it appears to work well in steady trending conditions and volatile stocks.

From experience TEMA can be defaulted reasonably well using 14 day or 21 day averages, and for a longer term trend indicator, a 70 day or 100 day TEMA might be appropriate. As with all indicators it is simply a matter of finding an approach that suits each individual trader.

It is possible to actually apply TEMA analysis to MACDs themselves, and some software systems include a custom indicator using this approach, but it is simply a question of trying it out.

After all, finding the underlying trend is just one out of many rules for successful trading.



About the Author:
Mike Estrey is the Head of Research for Blue Index, specialists CFD Brokers, providing seminars on how to trade CFDs and offering a Live Trading Simulator.