If you have seen anything more than a basic stock price chart – one that just has volume and stock prices featured on it – then you might have noticed the presence of a few odd-shaped lines that may not have made much sense.
These lines are called moving averages, and they can be some of the best tools you can use to determine what a stock will do and when it will do it.
Born of technical analysis, the theory that you can trade stocks based on purely technical matters of price, momentum, and market activity rather than the fundamental financial identity and performance of the stock itself, moving averages offer you the chance to glean hints and clues about what the price of a stock can or will do from the stock’s past performance. It’s not perfect, and sometimes is more of an art than a science, but trading with moving averages is still well worth learning for many traders.
What is a Moving Average?
In technical analysis, the price point is supreme. This is a single piece of data that forms the fundamental building block for all things technical. When you string a bunch of price points together, you can begin to pick out trends and uncover something that is considered sacred by technical traders (and balderdash to fundamental traders): momentum.
Momentum is loosely defined as a market force that, for whatever reason, causes a stock’s price to continue on in whatever direction it is in until some outside force causes it to do otherwise. So, when you are looking at momentum, you are attempting to figure out where the Market Forces That Be are pushing a stock’s price. Of course, technically a moving average doesn’t predict price; it only tells you what direction the stock is currently moving (with naturally lags real-time trading).
A moving average accomplishes this by taking the price points for a certain timeframe and averaging them together in a formula that “smoothes out” the data and identifies a trend. The price points used are most commonly the closing price for a stock at the end of each trading day over the timeframe.
Types of Moving Averages
You can theoretically have a moving average for any timeframe. But, the most commonly-used moving averages in stock trading today are 20-day MAs, 50-day MAs, and 200-day MAs. You can have these in two different flavors: simple moving averages and exponential moving averages.
SMAs are calculated by taking the average price of a stock over a certain number of trading days at the close of the trading period. The key thing to note is that with each day, the oldest bit of data is dropped and no longer included. So a three-day moving average might look like this:
Closing Prices: 1, 2, 3, 2, 3, 4, 5, 4
Day One: (1+2+3) / 3 = 2
Day Two: (2+3+2) / 3 = 2.33
Day Three: (3+2+3) / 3 = 2.66
Day Four: (2+3+4) / 3 = 3
Day Five: (3+4+5) / 3 = 4
An EMA tries to cut down on lag by throwing in a multiplier that applies more weight to the most recent prices. We’ll skip the calculations (there are plenty of programs and publications that do it for you); just know that the latest prices are factored in more heavily than earlier ones, as to make the average a bit more timely.
Which should you use? They’re good for different reasons; EMAs are more responsive, while SMAs are better for identifying levels of support and resistance.
As far as timelines go, the shorter the moving average, the less lag you’ll deal with. A long average has a lot more lag than a short one. The timeline you want to use should match your trading timeline. Short-term traders may not have a lot of use for a 200-day MA, but long-term traders would (which is why the 200-day MA is probably the most popular one). The 50-day MA is a nice compromise, I think, which is why many traders include it in their analysis.
Below is a chart of Exxon Mobil with 3 simple moving averages plotted, 20 (red), 50 (yellow) and 200 (turqoise).
Identifying Trends With MAs
So, you have moving averages. Now what?
You can use them by themselves to give you an idea of the general direction of a stock’s price – they work particularly well when a trend is strong – but they are more effective when used together.
One common technique is to take two MAs, say a 50-day MA and a 200-day MA, and watch for points when they cross each other (as indicated on a chart when you activate MAs). When the short MA crosses above the long MA, then the chart produces a bullish signal. The opposite is true for a bearish signal.
Incorporating the Moving Average Convergence-Divergence (MACD) indicator can help you better identify when signals are valid and good to follow and when they are false, or not indicative of a good buying/selling decision. If you use MACD, watch for when the signal line crosses below the MACD; that’s a bullish signal. A bearish signal is when the signal line crosses over the MACD.
You can also use Bollinger bands to help. Bollinger bands come complete with a moving average, an upper band, and a lower band. The purpose is to give you a relative definition of a high price and a low price for a stock.
You can tell how volatile a stock is by observing how close the bands are (closer = lower volatility; farther apart = higher volatility). Some traders also look for stocks whose prices are approaching either band. One strategy is to buy when stocks reach or touch the lower band and sell when they reach or touch the higher band.
One thing to not do is religiously follow moving averages when the stock or market is volatile and turbulent. Moving averages do not give much help there; they are best for when a stock or the market as a whole move in trends.
The best way to test any strategy with moving averages is to create a strategy, turn on MAs, MACD, and Bollinger bands, then back-test using back-testing software. Or, simply play around with various MA combinations and indicators on a practice trading account to get a good feel for how moving averages work.