103-11 Indicators – Moving Averages

The power of moving averages

Indicators may seem like something only Einstein himself can master, but everything is within reach here. You will have a solid understanding of a fundamental concept in just a few minutes. Indicators are lines that get plotted on a stock chart to simplify you to understand the history and perhaps the future of a stock.

103-11 Indicators - Moving Averages - 1

Moving averages are the staple diet of any chartist and enable you to visualize changes in trends in price. Moving Averages (MA) are a simple mathematical calculation that takes the average price (mean) for a given period and plots this on a chart.

So in the table to the right, the average price for the first five days = 3.8.

The key here is when we use 2 or 3 moving averages together; we see visually when the lines cross a stock’s trend is changing, and it may be time to look seriously at buying or selling a given stock.

Types of moving average

The simple moving average (SMA) – the example above is using the simple moving average

The exponential moving average (EMA) – this moving average uses a weighting factor to smooth out the data. A higher weight is placed on the most recent data, so the moving average line responds quicker with the latest price moves. This attempts to reduce one of the weaknesses in moving averages. This weakness is the fact that the moving average is a lagging indicator, and depending on the length of the moving average, it can take time for the MA to start moving in the direction of the stock price.

Offset moving average – whichever moving ordinary you use, you can offset the moving average. This is also another way of trying to reduce the lag. If you set an offset of +5, the moving average line will push 5 periods forward. If you are using a daily chart, this will push the MA 5 days ahead. You can also set minus numbers to offset the line back X periods.

In this example, we will use a chart with three simple moving averages (SMA’s) plotted.

MA50 (RED) – this is the moving average of the last 50 periods (in this case, days – it is a daily chart)

MA20 (Yellow) – this is the Moving Average of the last 20 days

MA10 (Orange) – this is the Moving Average of the last ten days

103-11 Indicators - Moving Averages - 2

The secret is in the combination of the indicators.

  • What do you see here?
  • Where do the lines cross?
  • What happens to the stock price after the lines cross?
  • What happens to the overall trend when the lines cross?

Buy & sell signals with SMA.

Here we are using three MA’s; you could also use two. You can set different moving average timeframes; the most common ones are: 10:20:50:200 day MA’s

If you are trading more short-term, use the lower Moving Averages (10, 20, and 50). If you buy and hold a stock for six months or more, use longer averages (50,100,200).

103-11 Indicators - Moving Averages - 3

As you can see, when the MA’s cross, this is the pivotal point that signals a change in trend.

Notes on the chart:

  1. The 10 days MA crosses up through the 20 day MA – Buy.
  2. The 10 day MA crosses down through the 20 day MA – Sell Warning. You could also use the price crossing down through the 20 days MA  or even the 200 days MA as a sell signal.
  3. Here all three MA’s cross each other in a short period, and the price crosses down through all the moving averages. This is a strong sell signal.
  4. Finally, the price moves vigorously up through the moving averages indicating a buy signal.

Of course, you can backtest the moving averages to see if they work on a previous timeline (by scrolling backward in the chart). Use them as a minimum indicator to help you envisage when a stock will move in your favor or move against you.

Moving averages are an excellent indicator based on price, and the price is the most important of all indicators.

Assess market direction using the 200-day moving average

In this section, you will learn how the 200-day moving average can be applied to a stock market index to help you understand the market’s general direction.

Stock Chart Setup

You can use any charting package to achieve this goal.

  • Select  a Weekly Chart – 5 Days Per Bar
  • Select your favorite index
  • Add a Simple Moving Average Indicator
  • Make it a DASHED LINE (optional)
  • Set the Moving Average to 40. We do this because if the chart is weekly, meaning 5 days per bar, then a 40 bar moving average is equal to a 200-day moving average.
  • We can refer to this as the Moving Average 40 on a weekly chart.

103-11 Indicators - Moving Averages - 4

The 200-day moving average is the bread and butter of the technical analyst or professional trader.

Use these rules to enable you to understand the 40 Bar Moving Average.

  1. When the price on the chart is above the 40 bar moving average, the index is in an up-trend (see the green boxes below)
  2. When the price fluctuates on or around the moving average, this means the stock is in sideways consolidation.
  3. When the price is clearly below the 40 bar moving average, the index is, of course, in a down-trend (see the red boxes)

So what is the rule to use to interpret this chart?

Ask yourself this question. On a weekly chart, do you want to be investing long (expecting price rises) when the price is below the 40 bar moving average (the RED BOXES)

Stock Market Investing Rules for Medium / Longer Term Traders

When the Price Pattern of the Index breaks down through the 40 bar moving average = Bearish = Sell = Go Short.

When the price pattern of the index breaks out above the 40 bar, moving average = Bullish = Buy = Go Long.

LEAVE A REPLY

Please enter your comment!
Please enter your name here