Traders are always searching for tools to give them an advantage in the fast-paced world of the stock market. A single move has the potential to grow or diminish your investments. The Displaced Moving Average (DMA) is one such instrument that has grown in popularity in the trading community. The purpose of this article is to provide you with an in-depth understanding of DMA in the stock market, including its definition and uses.
What is DMA in the stock market
DMA, or Displaced Moving Average, is a technical indicator that traders use to assess price patterns in the stock market. It determines a stock's average price over a given period but moves it back to a specific number of bars from the present price. This displacement causes a lag effect, giving traders insight into market patterns and prospective trading opportunities.
Why is DMA used in the stock market
The displaced moving average is mostly used in the stock market to determine trends and levels of support and resistance. By examining DMA's correlation with the current price, traders rely on it to provide them with insights regarding the direction of market movements.
Traders may make trading selections by being mindful of these trends. DMA is frequently used with additional technical indicators and tools for price research to improve trading tactics and decision-making. However, traders must keep in mind that DMA should not be viewed in isolation but rather in the context of the overall state of the market and other relevant information.
How DMA works
DMA shifts a stock's price back a certain number of bars from its present price by computing the stock's average price over a given time period. This displacement aids traders in predicting trends, support/resistance levels, and market turning points.
DMA example
DMA allows you to shift or centre the moving average on the price chart. Let us take a look at an illustration to see how DMA works. Suppose you aim to plot a 15-day displaced moving average. It will calculate the average of the last 15 closing prices and plot it 15 bars back, resulting in a lag effect. In this case, the DMA lags behind the current price action.
What does DMA tell you
The displaced moving average gives stock market traders insightful information that aids in their decision-making. What DMA can tell you is as follows:
- Trends in the market: DMA assists traders in determining the dominant trends in the stock market by comparing the average price with the current price. A DMA below the current price denotes an uptrend, whereas a DMA above the price shows a possible decline.
- Support and resistance: On the price chart, DMA can function as dynamic levels of support or resistance. There may be possible buying or selling opportunities for traders when the price bounces off the DMA.
Displaced moving average (DMA) vs. exponential moving average (EMA)
A type of moving average that traders use to examine price patterns in the stock market is called a DMA. It determines a stock's average price during the specified period but moves it back from the present price by a predetermined number of bars. The exponential moving average, or EMA, is another type of moving average employed in technical analysis. In contrast to DMA, EMA is more sensitive to changes in the market as it places greater weight on current price data. It uses a weighting factor on the most recent price data to get the average price of a stock.
Key differences
Calculation methodology
The calculation of the average of previous closing prices is done distinctly for EMA and DMA. EMA lends greater weight to recent prices, whereas DMA calculates the average of past closing prices and involves displacement of the average line. It showcases past trends in different periods by fixing a specific number of bars to go backwards from the current costs. Thus, EMA is more reactive to the current price changes.
Time lag
As mentioned, DMA calculation involves putting bars backwards to a specific number. This creates a smoothing-out effect and also causes a time lag. EMA, on the other hand, is highly responsive. It responds to price changes more sensitively and quickly with no inclusion of time lag.
Smoothing effect
Although both indicators aid in smoothing price data, DMA is comparatively less effective in reducing the noise of price data. EMA, on the other hand, is more efficient in terms of price noise reduction. Plus, it provides a better understanding of current market trends.
Areas of use
DMA is popularly used to filter market resistance and support. Plus, you can also spot short-term fluctuations using DMA. On the other hand, EMA is popular for its quick response to price changes and trendy strategies. You may also use them for short-term trading opportunities.
Pros and cons of DMA trading
Here are some of the pros that DMA trading offers:
A powerful tool
DMA is considered a powerful tool that can offer traders insights into market trends and price behaviour.
Helps in enhancing trading strategies
DMA, when clubbed with other trading strategies, can enhance decision-making.
Helps identify market trends
The main purpose of the DMA is to identify trends and support and resistance levels. When the DMA is higher than the current price, it shows a potential downtrend. A low DMA, on the other hand, indicates an upward trend.
Take a look at some of the cons of DMA trading :
Not always reliable
Like other technical analysis indicators, the DMA is not 100% reliable in all situations, especially trend reversals or support and resistance levels. DMA does not inherently include predictive calculations, so its forecasting accuracy is limited.
Time lag can bring delayed signals
Another drawback of DMA is its inherent time lag, which often leads to delayed signals. This makes DMA less useful for traders who seek confirmations on short-term strategies or want to capture rapid price changes.
Cannot be used in isolation
It is not recommended to use DMA as a standalone indicator. Relying only on DMA for decision-making in trading can easily lead to faulty signals and a misreading of market trends.
Limitations of displaced moving average
Despite its usefulness, traders have to be mindful of DMA's limitations:
Time lag
The time lag is one of the most prominent limitations of DMA. DMA, designed to adjust the lags of other standard averages, fails to serve its purpose 100%. This intrinsic time lag can cause delayed messages and signals or result in missed news and entries for traders. Thus, it is not a very effective tool for markets with rapid fluctuations or for traders looking to seal short-term price changes.
Subjectivity in displacement
In DMA, the traders are the decision-makers of the displacement time of the moving average. Thus, their varying views lack standardisation, making the whole process open to all kinds of interpretations with no common must-follow approach.
False signals in sideways markets
Because DMA is normally intended for moving markets, it may not be able to precisely capture market movements when they are less volatile. This results in losing track of current trends and misleading signals in range-bound or sideways markets.
Risk of over-reliance
You must not rely too heavily on DMA without taking into account other market elements like economic factors, market trends, and market demand. Sole reliance on DMA might limit a trader's perspective and lead to poor decisions. It is suggested that DMA should always be combined with other notable indicators like chart patterns and fundamental analysis.
Ineffective in uncertain markets
The smoothing effect of DMA makes it an ineffective tool for volatile markets or markets with choppy conditions. In markets where the volatility range is too high, DMA may give little to no relevant information on price movements and trading decisions.
Points to remember while relying on DMA In the stock market
Context matters: DMA works best in trending markets; thus, it should be used with caution in sideways or extremely volatile markets.
- Displacement is subjective: Try different displacement intervals to see which works best for your trading strategy.
- Use with other indicators: Combine DMA with additional technical indicators to verify signals and form a holistic understanding of the market.
- Beware of the lag: DMA can still lag behind real-time market movements even with displacement, so be cautious regarding this delay.
- Backtesting is key: Backtest DMA on historical data before using it in real trading to determine its effectiveness and make any necessary changes.
Conclusion
DMA is a useful tool for Indian traders who want to analyse market patterns and make informed stock market decisions. Traders can make trades with confidence if they understand its benefits, limitations, and recommended practices. Remember that DMA should be used in combination with other indicators to achieve the best results.
