What is it:
This page has pictured a three-month chart of the deviation moving average indicator coupled with the difference chart. The two lines on the indicator chart represent the movement of price (the blue line) against a 50-day moving average plus the respective 10-day percent deviation moving average (the orange line). The deviation moving average operates on the idea that there is a consistent percentage deviation in the current local trend. These consistent percentage deviation trends are calculated using data within the past 10 trading period. Jumps up and down from the 50-day moving average are taken to be irrational pricing in the market, but the trend of irrationality is measurable. More subtle sentiment shifts are noticed causing price to move relative to the initial deviation. Essentially, stock prices will become more jagged as intraday and intraweek trading causes “micro-deviations” from the consistent deviations calculated. More volatile securities will see larger spikes and a larger difference from the orange line.
How to use:
This indicator is not to be used if you are trading on a purely value-based strategy. Instead, technical traders should use this tool as a way to measure the strength of “irrational” or “crowded” trends. These kind of trends are important because they typically under- or over-value a stock compared to its actual value. Upon observation, one will notice that there are many crossover points between the two lines. At these points, the “micro-deviations” are switching and beginning a swing in the opposite direction. Unlike other momentum indicators, buy and sell signals are generated when the difference between the consistent deviation and the “micro-deviation” is the largest as it alerts the investor that a small price shift in the opposite direction is suggested. Technical traders can trade the security if they think they notice a peak in the difference between the blue and orange line. For this reason, the difference chart is helpful to recognize local reversals. Volatile stocks will have large differences, and thus, generate more buy and sell signals while stocks with a low beta will have smaller differences. Major, long-term reversals cannot be predicted by this indicator. Investors should recognize only the short-term validity of this indicator.