Given the adage that “the trend is your friend”, simply being able to identify the current trend for a given security can be important in helping you decide which stocks to trade. A moving average is a technical analysis trade tool that uses past price data and maps those points on a chart to help traders better verify trend activity when trading stocks online.
|Trend Indicator||Assesses and helps identify the:
|Lagging Indicator||Follows the price and describes past performance, does not predict it future price performance.|
Moving averages are most effective when used in the following market conditions:
Moving average components
Because a moving average represents the average closing price for a stock or other asset over a certain period of time, the moving average timeframe determines how responsive the resulting average will be to price fluctuations.
Moving average timeframes
Moving averages of various timeframes can be used to analyze a single security. The only difference is the number of days of data that are used in the calculation.
|Short-term timeframe||Typically range between 5 to 20 days and are useful at identifying swing trading trends lasting a few days to a few weeks.|
|Intermediate term||Typically range between 20 to 65 days, and are more useful at identifying position trading trends lasting a few weeks to a few months.|
|Longer-term||Typically range between 100 to 200 days, and are more useful at identifying general investing trends lasting a few months to a few years.|
Shorter moving average timeframes are more sensitive to price fluctuations and can pick up on trend changes more quickly than longer-term moving averages. However, these more frequent signals may also result in more “whipsaws”, resulting in erroneous trade signals.
Longer moving average timeframes are less sensitive to price fluctuations than shorter term timeframes and will generate far few signals. This will reduce the number of “whipsaws”, which is good, but will also generate signals later than when using shorter term averages.
Moving average types
There are a few different types of moving averages that are commonly used by traders. The difference among these types is simply the method used to calculate the moving average value
|Simple Moving Average (SMA)||Adds the closing price of the security for a number of time periods and then dividing this total by the number of time periods.|
|Weighted Moving Average (WMA)||The weighted moving average is calculated by giving more weight to the data for more recent days, unlike the simple moving average that gives equal weight to all days in the moving average time period.|
|Exponential Moving Average (EMA)||The exponential moving average is calculated by multiplying yesterday’s moving average value by one "smoothing factor", then multiplying today’s price by another "smoothing factor" and adding the two. The two "smoothing factors" combined always equal 1.00.|
Indicator signals: What traders look for
While moving averages are a very simple tool to use, like most technical indicators, different traders will focus on different ways to use them.
Crossovers: Identifying trend direction
Traders will often use multiple moving averages to analyze a single security. A longer-term moving average may be used to identify the primary price trend, a shorter moving average period to identify the secondary, price trend, and an even shorter moving average period to identify the minor price trend.
Types of crossovers
- Price crossovers - When price crosses above or below a moving average line.
- Double crossovers - When one moving average line crosses above or below another moving average line.
Support and resistance: Identifying trend strength
Moving averages can often act as support and resistance levels as price will often stop and reverse when it touches or nears a widely followed moving average.
- Area of support - If a stock is trading above the moving average, it is thought to have support at the moving average. Support represents an area on the chart that shows there is enough buying interest to keep the price of the stock from falling below a certain price point.
- Area of resistance - If a stock is trading below its moving average, it is thought to have resistance at that moving average. Resistance represents an area on the chart that shows there is enough selling interest to keep the price of the stock from rising above a certain price point.
Bullish price crossover
When price crosses above a shorter-term moving average it generates an early but often weak bullish trade signal. When price moves above a longer-term moving average it generates a later but often a stronger bullish trade signal.
Bullish double crossover
When a shorter-term moving average moves above an intermediate-term moving average it generates an early but often weak bullish signal. When a shorter-term or intermediate-term moving average crosses above a long-term moving average it generates a later but often stronger bullish trade signal.
Bearish price crossover
When price crosses below a shorter-term moving average it generates an early but often weak bearish trade signal. When price moves below a longer-term moving average it generates a later but often a stronger bearish trade signal.
Bearish double crossover
When a shorter-term moving average moves below an intermediate-term moving average it generates an early but often weak bearish signal. When a shorter-term or intermediate-term moving average crosses below a long-term moving average it generates a later but often stronger bearish trade signal.
Moving averages offer traders a simple tool for identifying important trends for a given stock or asset. By simply comparing the current price to where price has been recently it is possible to objectively designate the current trend as “up”, “down” or “sideways.” Given the value of trading in line with important trends, this can be a very useful piece of information.