The (f)law of averages!
Most of the investors are familiar with quite a few market averages, such as simple moving average (SMA), exponential moving average (EMA), average true range (ATR), among others. These averages come in handy to determine the likely movement of the stock, commodity or the index going forward and, accordingly, decide on the course of action to be taken. These averages are useful to identify the trend of the stock and determine the support and resistance levels.
However, it is not advisable to rely too much on these averages; firstly, because these are lagging indicators that are computed on the basis on the past movement in the price and therefore, going forward, there is no guarantee that the price would follow the same pattern as in the past. Secondly, these averages at times can give a misleading picture of the likely price movement.
Let us consider the example of the daily average true range (DATR). This indicator gives the investor a fair idea of the price range that a stock is likely to move during the course of a day. For example, if the closing price of a stock on the previous day is Rs 100 and the DATR is Rs 5, the DATR suggests that the stock would move up to Rs 105 or move down to Rs 95 (from previous day’s closing price of Rs 100) during the day or it could move in the range of Rs 98-103, or Rs 97-102, and so on. But this is not really so. The DATR is just an average for a given period (usually 14-day) and during that period, the range of the stock price movement might have been as wide as Rs 10 or as narrow as Rs 2 in a day and the average of the 14-day period works out to Rs 5. So, investors cannot assume that the stock price would remain within the DATR of Rs 5 and should, instead, take into account the minimum and the maximum price movement range before determining the support and resistance levels in conjunction with other indicators.
In short, averages can be useful when interpreted and applied correctly, but these can lead to disastrous consequences when misinterpreted or used incorrectly.