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4. Time-Based Trend Calculations

Learning Objective Statements

● Examine methods for forecasting price direction
● Calculate a simple approach to momentum
● Investigate various weighting methods for moving averages
● Explain the drop-off effect and its impact on technical indicators

1. The purpose of all trend identification methods is to remove the underlying noise in the market, those
erratic moves that seem to be meaningless, and find the current direction of prices.
2. But trends are somewhat dependent upon your time horizon.
3. There may be more than one trend at any one time, caused by short-term events and long-term
policy, and it is likely that one trader will search for the strongest, or most dominant trend, while
another will seek a series of shorter-term moves.
4. There is no “right” or “wrong” trend but a choice of benefits and compromises.

Forecasting and Following

1. Forecasting, predicting the future price, is much more desirable but very complex. It involves
combining those data that are most important to price change and assigning a value to each one. The
results are always expressed with a confidence level, the level of uncertainty in the forecast.
2. There is always lower confidence as you try to forecast further into the future.
3. The techniques most commonly used for evaluating the direction or tendency of prices both within
prior ranges or at new levels are called autoregressive functions. Unlike forecasting models, they are
only concerned with evaluating the current price direction. This analysis concludes that prices are
moving in an upward, downward, or sideways direction, with no indication of confidence.
4. All of these techniques make the assumption that past data can be used to predict future price
movement, and that the direction of prices today is the most likely forecast of the direction of prices
tomorrow.
5. For the most part, these assumptions have proved to be true.

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6. From a practical viewpoint, these trending methods are more flexible than the traditional regression
models, but to achieve success they introduce a lag
7. A lag is a delay in the identification of the trend.
8. Great effort has been spent trying to reduce this lag in an attempt to identify the trend sooner;
however, the lag is the zone of uncertainty that allows the technique to ignore most of the market
noise.

Least-Squares Model.
1. The least-squares regression model is the same technique that is used to find the relationship
between two markets—Barrick Gold and cash gold, corn and soybeans—or to find how price
movement could be explained by the main factors influencing them, supply and demand.
2. Most trading systems depend only on price; therefore, we will look again using the least-squares
model with time as the independent variable and price as the dependent variable.
3. The regression results will be used in an autoregressive way to forecast the price n-days ahead, and
we will look at the accuracy of those predictions.
4. The slope of the resulting straight line or curvilinear fit will determine the direction of the trend.

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Error Analysis

A simple error analysis can be used to show how time works against the predictive qualities of regression, or
any forecasting method.
Using 10 years of General Electric (GE) prices, ending February 15, 2010, the slope and y-intercept are
calculated for a rolling 20 days.
The 1-, 2-, 3-, 5-, and 10-day ahead forecast is found by projecting the slope by that number of days. The
forecast error is the difference between the projected price and the actual price.
Figure above shows the price for GE from December 31, 2010, through February 15, 2011, along with the
five forecast prices.
Even though the price move seems to be increasing steadily, the forecasts get farther away as the days
ahead become larger.
This result is typical of forecasting error, regardless of the method, and argues that the smallest forecast
interval is the best.
The standard deviations of the five forecast errors(Figure below) , taken over the entire 10 years, shows the
error increasing as the days-ahead increase.
This confirms the expectation that forecasting accuracy decreases with time and that confidence bands will
get wider with time. For this reason, any forecasts used in strategies will be 1-day ahead.

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Limiting the Forecast to Direction

To be profitable trading a trending system, it is only necessary to be correct in one of the following two cases:
1. In more than 50% of the days you are correct in predicting whether prices will go up or down and the
average up move is equal to the average down move.
2. Your forecast accuracy is less than 50% but the size of the correct moves is greater than the size of
the incorrect moves.

Experience shows that the best choice of trending method will be the one that is profitable over most markets
and most calculation periods.

Even then, shorter calculation periods have no trend, so we need to restrict our statement to longer periods.

Price Change over Time

1. The most basic of all trend indicators is the change of price over some period of time. This is written
as

where M is called momentum, t is today, and n is the number of days. Sometimes this is called rate of
change, but both momentum and rate of change are incorrect names.

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2. If the change in price is positive, we can say that the trend is up, and if negative, the trend is down. Of
course, this decision is based only on two data points, but if those points are far enough away from
each other, that is, if n is large, then the trend as determined by this method will be very similar to a
simple moving average.
3. 0

The Moving Average

The most well-known of all smoothing techniques, used to remove market noise and find the direction of
prices, is the moving average (MA).
Using this method, the number of elements to be averaged remains the same, but the time interval advances.
The selection of the number of terms, called the calculation period, is based on both the predictive quality of
the choice (measured by the error but more often by the profitability) or the need to determine price trends
over specific time periods, such as a season.

What Do You Average?

1. The closing or daily settlement is the most common price applied to a moving average.
2. A popular alternative is to use the average of the high, low, and closing prices, representing some sort
of center of gravity.
3. You may also try the average of the high and low prices, ignoring the closing price entirely.
4. Another valid component of a moving average can be other averages.

Types of Moving Averages.

The Simple Moving Average.

The simple moving average is the average (mean) of the most recent n days. It has also been called a
truncated moving average, and it is the most well-known and commonly used of all the methods.
The main objection to the simple moving average is its abrupt change in value when an important old piece of
data is dropped off, especially if only a few days are used in the calculation

Average-Modified or Average-Off Method

To avoid the end-off problem of the simple moving average, each time a new piece of data is added the
previous average can be dropped off. This is called an average-modified or average-off method.
It is computationally convenient because you only need to keep the old average value rather than all the data
that was used to find the average.
The substitution of the moving average value for the oldest data item tends to smooth the results even more
than a simple moving average and dampens the end-off impact..

Weighted Moving Average.

The weighted moving average opens many possibilities.
It allows the significance of individual or groups of data to be changed.

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It may restore perceived value to parts of a data sample, or it may incorrectly bias the data

Triangular Weighting
1. Triangular weighting or triangular filtering attempts to uncover the trend by reducing the noise in both
the front and back of the calculation window, where it is expected to have the greatest interference.
2. Triangular weighting is often used for cycle analysis.

Pivot-Point Weighting
1. The pivot-point moving average uses reverse linear weights (e.g., 5, 4, 3, …) that begin with a positive
value and continue to decline even when they become negative.
2. The intent of this pattern is to reduce the lag by front-loading the prices.
3. For a short interval this can cause the trendline to be out of phase with prices.
4. This method seems best when used for longer-term cyclic markets, where the inflection point, at
which the weighting factor becomes zero, is aligned with the cyclic turn or can be fixed at the point of
the last trend change.

Standard Deviation Moving Average

1. A unique trend calculation technique uses the standard deviation of prices.
2. This method creates a comparatively smooth trendline.

Geometric Moving Average.

1. The geometric mean is a growth function that is very applicable to long-term price movement.
2. It is especially useful for calculating the components of an index.
3. The geometric moving average itself would give greater weight to lower values without the need for a
discrete weighting function.
4. This is most applicable to long data intervals where prices had a wide range of values. In applying the
technique to recent index or stock prices, this distinction is not as apparent.

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Accumulative Average
1. An accumulative average is simply the long-term average of all data, but it is not practical for trend
following.
2. One drawback is that the final value is dependent upon the start date.
3. If the data have varied around the same price for the entire data series, then the result would be good.
4. It would also be useful if you are looking for the average of a ratio over a long period.
5. Experience shows that price levels have changed because of inflation or a structural shift in supply
and/or demand, and that progressive values fit the situation best.

Reset Accumulative Average

1. A reset accumulative average is a modification of the accumulative average and attempts to correct
for the loss of sensitivity as the number of trading days becomes large.
2. This alternative allows you to reset or restart the average whenever a new trend begins, a significant
event occurs, or at some specified time interval, for example, at the time of quarterly earnings reports
or at the end of the current crop year.

Drop-Off Effect
1. Many rolling trend calculations are distinguished by the drop-off effect, a common way of expressing
the abrupt change in the current value when a significant older value is dropped from the calculation.

2. A front-weighted average, in which the oldest values have less importance, reduces this effect
because older, high-volatility data slowly become a smaller part of the result before being dropped off.
3. Exponential smoothing is by nature a front-loaded trend that minimizes the drop-off effect as does the
average-off method

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