August 7th, 2008

The Difference between Trendlines and Moving Averages

Trend analysis assumes that an uptrend remains intact so long as new highs and lows (pivot points) are higher than previous highs and lows; a downtrend assumes the opposite. A pivot point is when the trend of prices changes direction.

Trendlines and moving averages are often used interchangeably and, often, incorrectly to describe a prices trend. First of all, they’re not the same thing at all.

  • A moving average is the daily calculation of an average of the actual closing values of a series (like the S&P 500 Index or the closing price of an individual stock) for “x” number of prior days (I’m ignoring exponential moving averages here). When calculated and plotted each day, the movement of the average relates not only the current value of the Index or stock to the average of the prices over the past x number of days (is it higher, or above, the average) but also compares the current average with all the prior calculated averages.

    It’s generally assumed that a moving average acts as some sort of a wall or support some how restraining or constraining the prices movement. It does not such thing. A 30-day or 60-day or a moving average over any number of days may or may not appear to act as a support (or resistance) to a prices trend but only if the right number of days is selected. One moving average may work well for one stock but the prices of another stock could continually “violate” the same moving average.

    Finally, a series that isn’t trending either up or down will straddle any moving average, regardless of the nearly any number of days, by definition.

  • A trendline, on the other hand is the extrapolation of a vector of where hypothetical past and future potential pivot points. A trendline connects a minimum of two and preferably more actual prices over any historical time period and projects likely future pivot points might be. More correctly, if future pivot points do, in fact, materialize someplace where a trendline extrapolated out said it might then it is assumed that the factors generating the prior pivot points remains in force and therefore the trend remains in force.

    The selection of the two (or a just a few more) historical prices used to generate the vector of future pivot points (the trendline) is critical since, theoretically, an infinite number of trendlines can be extrapolated into the future. In my experience, horizontal trendlines (for example, an extrapolation from a pivot point representing a previous high or low) is significantly more reliable than trendlines (extrapolations) that are either downward or upward sloping. By extension, the steeper the slope of the trendline, the less reliable.

A good example of actual trendlines and moving averages is WRES (Warren Resources), a stock a reader inquired about on May 24 including the following chart:

At the time, I wrote:

I inserted a second, dashed line at around 15.12, a potential resistance trendline connecting 5-7 pivot points since 12/31/2005 (depending on whether you count the near hits in June 2006). Buyers were unable to generate sufficient momentum each of these times for either economic, industry or company reasons.

With some believing that the best moves for stocks in the Oil & Gas Industry Groups is temporarily behind us, it may be late for more big moves. The risk for any owner of WRES is that should it be able to break through the upper boundary of that symmetrical triangle, it would be tested and stalled at that dotted resistance trendline.

I think I’d give up the move from the current 13.77 to 15.12 (yes, that’s about 10%) as insurance and buy when and if it breaks through that resistance trendline. At least your money won’t take a loss if the stock sellers ultimately win and the stock breaks through the bottom boundary or the triangle or be sitting for weeks or months waiting for that break through the resistance at the 15.12 trendline.

So have things turned out? Here’s an udated chart for WRES:

The stock did move up the horizontal dotted line and then retreated. The trendlines defining the symmetrical failed but the horizontal trendline, an extrapolation of possible future pivot points based on prior pivots at that price, was accurate. It’s unclear at this point whether the lower, upward sloping trendline will hold and, if so, whether WRES will try for the 7th or 8th time to break above the horizontal resistance trendline.

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