Technical analysis—the buying and selling of stocks based on the study of price movement, volume, and trends—requires different kinds of trading tools than does fundamental analysis—the study of the companies behind the stocks. Technical indicators are what traders use. One of the simplest ones, which has been in use a long time, is moving averages.
Moving Averages Help Filter Out Volatility
A moving average is the average of a number over a set period of time that is recalculated each time another number is added to the end of the period. Figure 1 shows twenty days of a stock’s closing price, with a 10-day moving average calculated. As can be seen from looking at the stock price, it goes up and down, and picking out the trend is difficult. However, the moving average tends to “filter” out this volatility, and it shows the stock price trending upward.
Figure 2 is a stock chart that includes a 50-week moving average (the green line) and a 200 week moving average (the red line). Notice how the 200-week MA is a smoother line than the 50-week MA, and how both lines are smoother than the stock price line. This allows the stock trader to see the trend with considerable clarity. It also shows when there is no clear trend, when the line is almost horizontal.
Traders will use a mix of moving averages. Figure 3 shows a stock chart with the following moving averages shown.
- 200 day MA
- 50 day MA
- 20 day MA
- 13 day MA
The first three are calculated as simple moving averages. The last is calculated as an exponential moving average.
The slope of the moving average line not only shows the trend, but also indicates the strength of the trend. A moving average that is steep, either up or down, indicates a strong trend.
How Traders Use Moving Averages to Time Buy-Sell Decisions
The most common ways in which stock traders use moving averages are:
- Crossovers of the stock price and the moving average
- Change in direction of the moving average line
When the price of a stock crosses over the moving average line, this frequently indicates that a change in trend has taken place. A stock price that is moving up and that crosses the moving average can be said to be in an uptrend (usually confirmed by other indicators or observation of the stock chart). This is a buy signal. Conversely, when a stock price is falling and moves below its moving average, this is a sell signal, or possibly the signal for a short trade.
When a moving average changes direction, this is an indication of a reversal of a trend. On the stock charts shown in Figures 2 and 3, many places can be seen where any of the moving averages shown reverse direction. In almost all cases the stock price followed through with a trend that corresponded to the moving average. This is common sense, but the moving average line(s) helps the trader see this more clearly.
Moving Averages Tend to Lag the Trend of the Stock Price
The problem with moving averages is that they tend to lag what is happening in a stock price. For a 20 day MA, by the time the MA line shows a reversal of the trend, the trend has already been happening for half the calculation period, or ten days. Thus timing stock buying or selling will result in less profit potential, since buying and selling will occur after the peaks.
This also means that the moving average tends to be perhaps a better indicator to use than some other things. Once a stock crosses a moving average (especially the longer term moving averages, it tends to remain moving in that direction longer.
Use of Multiple Moving Averages
Because moving averages tend to lag the true stock price trend, traders will use moving averages in conjunction with other indicators, or they will use multiple moving averages, as described above. Again, Figure 3 illustrates how four moving averages are plotted together. Each of the moving averages has a different relationship to the stock price, and in its own way can be used to confirm what the other moving averages are indicating.
Moving averages are a powerful technical indicator, used in stock trading, Forex trading, and commodities trading to help traders recognize trends, and time purchases and sales according to the direction, strength, and reversal of the trend.
References:
Steven B. Achelis, Technical Analysis from A to Z, pages 71-74; 2001, McGraw-Hill
Martin J. Pring, Technical Analysis Explained, pages 174-177; 2002, McGraw-Hill
David A. Todd - David Todd is a civil engineer, a genealogist, a citizen concerned with the environment, and a writer by passion.
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