Technical analysis is a study of stock price data and patterns that have been around even before the advent of computers. Stock market researchers have been studying and experimenting with moving averages for over a century.
Since the invention of computer and electronic trading, moving averages have been more widely accepted and more thoroughly tested. In this article, we will study displaced moving averages or the DMA meaning in stock markets, but first, we will take a quick look at Moving averages (MA) and their types.
Brief explanation of moving averages
Moving averages is a tool used for determining the direction of the trend. It is used to understand whether the markets are moving in an uptrend or a downtrend.
There are many types of moving averages in time series forecasting; only two are commonly used in the field of technical analysis. These are simple moving averages and exponential moving averages.
Simple Moving Average (SMA):
SMA is created by adding the past ‘n’ number of data points divided by a number of observations. As a new data point is created, the earliest one is dropped.
For example, to calculate a 10-day SMA for daily price data, on day 10, the average of prices is taken for the last 10 days. On the 11th day, the day 1 data point is dropped and the same process is repeated for data from day 2 to day 11.
Exponential moving average (EMA):
SMA has an issue in that it completely ignores the past data that falls out of its calculation period. To solve this issue, an EMA is used, which gives more weight to recent data and less weight to past data, not ignoring it entirely.
Now that we have understood moving averages briefly, we will take a look at the Displaced moving average.
Also read: Here’s how you can use the MACD indicator
Displaced Moving Average(DMA)
Moving averages are a lagging indicator, meaning that they give a delayed reaction to price changes. Moving averages will start trending much later than price. To solve this problem a displaced moving average is used.
A displaced moving average means shifting the moving average forward or backward in time (or shifting it right or left on the price graph). When the moving average is displaced left or back, it is called negative displacement. When it is moved forward or right, it is called positive displacement. A displaced moving average can be created using any type of Moving average.
For example, when analyzing an uptrend, technical analysts move a simple moving average left (backward) to superimpose it on the price action. This helps in clearly seeing the direction of the trend and possible support and resistance levels.
Use of displaced moving averages
Displaced moving average can be used to identify trends in a trending market at spot potential trend reversals. Whereas in a sideways market, displaced moving averages are used to identify support and resistance levels.
For example, while analyzing a trend using a 20-period moving average shifted 5 periods to the left. This displaced moving average can be used to identify early reversals if the price moves below or above the DMA.
Also read: What is ADX indicator? Make informed trades by tracking market trends.
DMAs are also used to make technical indicators and strategies. For example, a very common strategy to identify trend and trend reversal is a SMA-DMA crossover. In this strategy, a 20-period SMA and a DMA (that is 20-period SMA shifted 5 periods to the left) are used.
The buy signal is when the DMA crosses above the SMA, and the sell signal is given when the DMA crosses below the SMA. This kind of strategy works best in a trending market.
This is one of the many strategies which are widely used for trading and analyzing markets using the DMAs. Now let us look at some limitations of DMAs in the stock market.
Limitation of a DMA
When numerous market participants utilize a technical analysis tool, it loses its predictive abilities. Moving averages and Displaced moving averages have been used for over half a century. Most traders and participants use these basic technical analysis tools across various time frames. Profit opportunities using MAs and DMAs solely are fading rapidly.
Secondly, there has been little to no backtesting of displaced moving average systems to say that these have statistically significant predictive powers. Before using any DMA strategy or tools it must be tested on past data. Those tests must be on different markets in terms of volatility, liquidity, trending nature, etc.
DMAs or any technical tools usually work best when applied along with other tools. The significance of the signal increases when it comes from various technical indicators at the same time. However, testing and using many indicators can be very complex for a retail trader.
Also read: Technical Analysis Tools: Uses, and Examples Explained
Bottomline
Displaced moving averages are used widely by traders and researchers alike. Now that you have understood what DMA is in the share market, it does not mean you can directly apply these in trading and expect to get rich overnight. Use of DMAs or any other technical tool is completely subjective and before putting your real money in any DMA strategy, first thoroughly back-test it, understand its risk profile, and follow strict risk management rules.
FAQs
1: Does a DMA have guaranteed return?
No strategy, tool, or security has guaranteed return. Risk has an all-pervasive nature as it exists everywhere in varying degrees. The return on any DMA strategy will depend on how well it is back-tested and researched and how good the risk management is.
2: Can you use any moving average to create a DMA?
In simple words, a DMA is created by shifting a moving average left or right. It does not matter which moving average is being used. It can be an EMA, SMA, Geometric moving average, harmonic moving average, etc.
3: Is using the DMA risky?
Not just the DMA but using any technical analysis tool or strategy is risky. Some are riskier than others. So, back-test your tool properly before using it in real markets, and follow strict risk management rules. DMAs are more likely to work better with other technical tools.
4: How does DMA differ from SMA?
An SMA or a simple moving average is just the average price of a given number of periods. But a DMA is created using an SMA when an SMA is shifted towards left or right it becomes a DMA. Both are useful in their ways.
5: Can DMAs be used to study Nifty50 futures?
A technical analysis tool that is properly back-tested and is proven to have statistical significance can be used in all liquid markets. Since Nifty50 futures are highly liquid, a properly researched and back-tested DMA tool can be used with proper risk management.
