Moving Averages - an Introduction:
Technical analysis has been around for decades, over the years there have been several indicators devised by professors, brokers, analysts and others. Some of them more effective and popular than others.
The moving average is one of the most useful, objective and oldest analytical tools around. Some patterns and indicators can be somewhat subjective, where analysts may disagree on if the pattern is truly forming or if there is a deviation that is might be an illusion. The moving average is more of a cut-and-dry approach to analyzing stock charts and predicting performance, and it is one of the few that doesn't require a genius intelligence to interpret..
This tutorial will try to shed some light on moving averages and hopefully add this useful indicator into your toolbox of analytical tools.
What is the Moving Average?
Moving average is an indicator that shows the average value of a
security's price over a period of time. To find the 50 day moving
average you would add up the closing prices (but not always[sigma]more
later) from the past 50 days and divide them by 50. And because
prices are constantly changing it means the moving average will
move as well.
The most commonly used moving averages are the 20, 30, 50, 100,
and 200 day averages. Each moving average provides a different interpretation
on what the stock price will do. There really isn't just one "right"
time frame. Moving averages with different time spans each tell
a different story. The shorter the time span, the more sensitive
the moving average will be to price changes. The longer the time
span, the less sensitive or the more smoothed the moving average
will be. Moving averages are used to emphasize the direction of
a trend and smooth out price and volume fluctuations or "noise"
that can confuse interpretation.
Here is a visual example using the stock price of AT&T:
Notice back in September when the stock price dropped well below
its 50 day average (the green line). There has been a steady downward
trend since then and no real strong divergence,
until the end of December where it rose above its 50 day average
and continued to rise for several weeks.
Typically when a stock price moves below its 50-100 day moving average
it is a bad thing, the opposite is true for stocks that protrude
their moving average.
So what do the different days mean?
The general assumption behind all moving averages is that once the
stock price moves above the average that it may substantial momentum
behind it and is worth buying. The opposite is true if the price of
a security moves below the moving average. It's a pretty simple approach
to technical analysis, perhaps the simplest of them all, but plain
and simply it works, and it is the base for many other much more complicated
20 day - provides a very volatile, choppy line. It isn't the
most accurate, but is probably the most useful for short term traders.
30 day - similar to 20 day but provides a bit more certainty
for the trend.
50 day - moving averages provide a much less volatile, smooth
line. This can be used to detect somewhat longer term trends.
100 day - similar to the 50 day, it is less volatile, and one
of the most widely used for long term trends.
200 day - even less volatile, more of a rolling chart or smooth
line. It doesn't react to quick movements in the stock price therefore
it is rarely used.
Again, there isn't just one "right" time frame. Moving averages with
different time spans each tell a different story. The shorter the
time span, the more sensitive the moving average will be to price
changes. The longer the time span, the less sensitive or the more
smoothed the moving average will be.
Some Strategies Using Moving Averages
Different investors use moving averages for different reasons. While
some use it as their primary analytic tool others simply use the moving
average as confidence builder to back their investment decisions.
Here are two other strategies that people use moving averages for:
Filters: Filtering is used to increase your confidence about
an indicator. There are no set rules or things to look out for when
filtering, just whatever makes you confident enough to invest your
money. For example you might want to wait until a security crosses
through its moving average and is at least 10% above the average to
make sure that it is a true crossover. Remember, setting the percentile
too high could result in "missing the boat" and buying the stock at
Another filter is to wait a day or two after the security crosses
over, this can be used to make sure that the rise in the security
isn't a fluke or unsustained. Again, the downside is if you wait too
long then you could end up missing some big profits.
Crossovers: Using Crossovers isn't quite as easy as filtering.
There are several different types of crossover's, but all of them
involve two or more moving averages. In a double crossover you are
looking for a situation where the shortest MA crosses through the
longer one. This is almost always considered to be a buying signal
since the longer average is somewhat of a support level for the stock
For extra insurance you can use a triple crossover, whereby the shortest
moving average must pass through the two higher ones. This is considered
to be an even stronger buying indicator.
The Different Flavors:
Of course the simple moving average that we've discussed it the
most popular, but there are different modified versions of the moving
Exponential Moving Average (EMA) - Are calculated by applying
a percentage of today's closing price to yesterday's moving average
value. Use an exponential moving average to place more weight on
Moving Average Convergence Divergence (MACD) - quite common,
the "MACD" is a trend following momentum indicator that shows the
relationship between two moving averages of prices. To Calculate
the MACD subtract the 26-day EMA from a 12-day EMA. A 9-day dotted
EMA of the MACD called the signal line is then plotted on top of
the MACD. There are 3 common methods to interpret the MACD:
1. Crossovers - When the MACD falls below the signal
line it is a signal to sell. Vice versa when the MACD rises above
the signal line.
2. Divergence - When the security diverges from the
MACD it signals the end of the current trend.
3. Overbought/Oversold - When the MACD rises dramatically
(shorter moving average pulling away from longer term moving average)
it is a signal the security is overbought and will soon return to
Other less common moving averages include triangular, variable,
and weighted moving average. All of them being slight deviations
from the ones above and are used to detect different characteristics
such as volatility, and weighting different time spans.
The moving average is one of the most popular and easy to use tools available for technical analyst, and wannabees for that matter. By using an average of prices, moving averages smooth a data series and make it easier to spot trends. This can be especially helpful in volatile markets, it smoothes out any noise and gives you a strong trend for the stock price.
There are several different varieties and time spans that one can use moving averages for, this is subjective depending on who you talk to. I prefer the 50 or 100 day average, but short term traders look at the 20 day average much closer. I hope this has helped shed some light on the wide range of uses for moving average and that it will help you pick better performing stocks.
© Copyright 2005 WebRadio Decibel Amsterdam.
Last update: 14-04-2005; 13:52:55.