How To Use Moving Averages

Moving averages in a nutshell

The most common types of moving averages are the SMA (Simple Moving Average) and the EMA (Exponential Moving Average).

The SMA takes a stock’s prices over a given period and averages those prices. A line is then drawn to represent the average price over time. Simple Moving Averages are slow to react to recent price changes.

An Exponential Moving Average is calculated in a similar manner to the SMA except that the EMA places more weight on recent prices. This means that they react more quickly than SMAs to recent price action.

Some traders like SMAs, others prefer EMAs. I only use EMAs. I find that SMAs aren’t a good fit for the types of stock chart analysis that I perform. In my opinion, EMAs respond better.

Two important things to realize about moving averages, no matter what type you are considering . . .

• they are lagging indicators. They show you where the price has been. They don’t predict future price movements.
• they only work in trending markets where there is a clear and distinct trend. They don’t work in ranging markets where the price is bouncing up and down between support and resistance levels.

Note: regarding “trending” and “ranging” stocks. Some traders use an indicator called ADX (Average Directional Index) to determine if a stock is “trending” or “ranging”.

Uses of moving averages

Note: we are only going to consider “long trades” (a trade where you ride a trend upwards, as opposed to “short trades” where you bet on the price going lower) in this article.

Trend strength can be indicated with moving averages according to the angle of the slope. A steeper slope means a stronger trend.

If you use two moving averages on the same chart, one slow and the other one fast, you can get an idea of the strength of the trend by observing how far apart the two moving averages spread as they rise.

Two very common MAs are the 50-day and 200-day. The 50-day (the faster MA) represents the intermediate-term trend and the 200-day (the slower MA) represents the long-term trend. If both MAs are rising and pulling apart then the trend is strong.

Moving averages can be used to generate buy and sell signals. Here are some common examples:

• buy when the price closes above a rising moving average.
• sell when the price closes beneath a moving average.
• buy after the “bullish crossover” of two moving averages. A bullish crossover occurs when a faster moving average crosses from below to above a slow moving average. This is a signal that a new trend might be developing. How long the new trend will last is an entirely different matter. A savvy trader might wait for confirmation that the trend is well established before jumping in.
• in a multiple moving average system where each timeframe (short-term, intermediate-term, and long-term) is represented by one or more MAs, enter a long position after all MAs compress together and then turn up.

You may hear traders talk about the “Golden Cross” and “Death Cross”. What they are talking about is simply the bullish crossover (in the case of the Golden Cross) and the bearish crossover (in the case of the Death Cross) of a shorter-term and a longer-term MA.

Often traders will use a 50-day MA (representing the intermediate-term trend – this is the shorter-term MA) and a 200-day MA (representing the long-term trend – this is the longer-term MA) when talking about a Golden Cross or Death Cross.

Market and sector analysis

As a trader you need to regularly monitor the dominant trends of the:

• stocks in your portfolio
• overall market (via an index such as the S&P 500)
• markets sectors (via sector index charts)

The intermediate- and long-term trends are the most important. 50-day and 200-day MAs are adequate for determining the state of the market and its sectors.

Before buying a particular stock, part of your trading plan might insist on the overall market that you’re investing in be above rising 50-day and 200-day MAs. You may also want to see that the two MAs are spreading apart (indicating trend strength).

You can use 50-day and 200-day MAs to analyze the technical health of individual market sectors, in the same way that you do for the overall market.

Trading in the direction of the overall market increases your chances of a successful trade. Monitoring the dominant market trends is part of a trader’s due diligence.

Converting between weekly and
daily moving averages

1 week = 5 trading days

To convert a daily moving average to a weekly moving average you simply divide the daily MA by 5.

i.e. 20-day EMA = 4-week EMA

To convert a weekly moving average to a daily moving average, multiply the weekly MA by 5.

i.e. 10-week EMA = 50-day EMA

Summary Points:

• Moving averages make trends obvious
• EMAs (Exponential Moving Averages) display recent price action more clearly than SMAs (Simple Moving Averages)
• Moving averages are lagging indicators – they don’t predict the future
• Moving averages only work in markets where there is a clearly defined trend. They don’t work in ranging markets
• A long-term moving average displays the most important trend
• The two most important attributes displayed by moving averages are trend direction and strength
• Moving averages provide a practical way to analyze a trend. They aren’t the “be all and end all” of trend analysis, but they do provide an excellent foundation for further investigation.

• How to read stock charts
• How to use moving averages
• Support and resistance levels - how to use them
• Stock trend analysis - medium-term

Please note that the information provided in this article is not investment advice. It is purely for educational purposes.

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