As per definition, DMA is a simple moving average that has been adjusted forward or back in time to fit a line of trend. Moving average indicator helps in tracking the dynamic prices of stocks more accurately.
How DMA works?
To understand how daily moving averages function we need to know the principle behind moving averages. Moving average with respect to a stock represents the movement in average price of the the stock with respect to time.
The fluctuations in the average prices are plotted on a time series graph in relation to the actual prices of the stock in corresponding period and the behaviour of the 2 graphs are assessed to predict the trend of any particular stock in the market.
There are three types of moving averages: simple, exponential and linear. Out of these, Simple moving average is the most widely used type.
DMA charts and periodicity
MAs help technical chart analysts read the short medium and long term trend in a stock and then predict a path going forward.
Standard DMA charts can be plotted for any period of time ranging from a week, a month or a year. The period is determined by the length of trade. Short term traders look into 20 or 30 day moving averages while medium and long term traders can refer to 200 day moving average charts to see the trend of a stock.
While the short term charts help in determining the rapid fluctuations with respect to bullish or bearish trends, the long term charts help in bypassing the drastic fluctuations and eliminate short-term instabilities o give a big picture of stock performance.
How is DMA helpful for traders?
DMA can indicate the direction of a trend as well as potential areas of support and resistance. This helps in determining buy and sell signals for a stock.
Direction of the trend
Simply put, a trend is a price that keeps moving in a particular direction. There are only three real trends that a security can follow:
- An uptrend, or bullish trend, means that the price is moving higher.
- A downtrend, or bearish trend, means the price is moving lower.
- A sideways trend, where the price is moving sideways.
Usually, the DMA aids in identifying trend direction. When the line of price is above the line showing DMA, it is more likely to be in an uptrend or at least to be above average.
On the other hand, when the price is below the line of moving average, it is usually an indicator of a downtrend.
Sometimes the prices run parallel to the X axis (horizontal) for some period of time in that situation the moving average of those days depict a sideways trend.
A change in trend may be indicated when the price intersects the line of moving average. Furthermore, it may indicate that a downtrend is beginning if the price line cuts through the line of moving average from above, which would indicate that the uptrend has ended.
When a price intersects through DMA line, a trend reversal may be imminent.
Areas of support and resistance
If the value of a stock is falling, traders wait for it to reach a certain level called 'support' before buying. This means if on a DMA chart the line of actual price starts falling and eventually bounces off after touching the line of moving average, the point of contact represents the area of support. This point suggests the right time to buy a stock as the prices will go up after that point.
Similarly adjustments are made to the displaced moving average in downtrends so that it is equal to the pullback highs. The trader can keep an eye on future pullbacks to see if the DMA still acts as resistance. If it does, that might present a chance for a short trade.
Point to remember while relying on DMA
At times the movement of price graph in relation to the DMA is choppy. There whipsaws on the chart, meaning rapid intersections of price and MA line, which make it difficult to determine the buy and sell signals.
To tackle the confusion caused by whipsaws, it is better to look into charts of longer period where rapid fluctuations get smoothed out to give a better idea of trends.
Limitations of using DMA
Like all technical statistical tools, DMA also has certain limitations and cannot be used as a universal measure to determine trade actions. A DMA is not always accurate at detecting trend reversals or levels of support and resistance, like many other technical analysis indicators.
This indicator may not contain any embedded predictive calculations, which limits the accuracy of its forecasts.
While predicting trends
Moving averages generally offer more useful information when markets are trending but little when they are choppy or moving sideways. The price will oscillate back and forth across the MA during these times, but since the price is generally moving sideways, crossovers are unlikely to present highly profitable trading opportunities and may even result in losses.
While watching for support or resistance
Signals for reversal, support, and resistance might not always be effective. The price may pass through an MA before turning around and moving in the opposite direction. While the MA might have offered assistance or opposition in the past, it might not do so in the future.
