The most common applications of moving averages are to identify the trending direction and determine support and resistance levels. One can also say that moving averages are used to smoothen out the ‘noise’ of short-term price fluctuations, so as to be able to identify and define significant underlying trends more readily.
When calculating a moving average, a mathematical analysis of the stock’s average value over a predetermined time period is made. As the stock price changes, its average price moves up or down.
Let’s take a look at this indicator and how it can help traders follow trends to make higher profits. There can be no complete understanding of moving averages without an understanding of trends. Simply put, a trend is a price behaviour in a certain direction.
There are five popular types of moving averages (simple, exponential, triangular, variable and weighted moving averages). However, the only significant difference between these different types of moving averages is the weight assigned to the most recent data.
The most popular method of interpreting a moving average is to compare the relationship between the moving averages of the security’s price with the price itself. The direction and place of a moving average convey important information about the price: a rising moving average shows the prices are generally increasing, while a falling moving average indicates that the price, on average, is falling.
While a price placed above the long-term moving average reflects an overall uptrend, the price placed below a long-term moving average reflects an overall downtrend. A ‘buy’ signal is generated when the security’s price rises above its moving average, while a ‘sell’ signal is generated when the security’s price drops below the moving average.
Some traders use the moving averages to not only identify index/stock trends but also to determine entry and exit strategies. Crossovers are one of the main moving average strategies. Moving average crossovers are a popular strategy for both entries and exits, while another strategy is to apply two moving averages: one long term and one short term to figure out a trend. When the shorter-term MA crosses above the longer-term MA, it gives a ‘buy’ signal, as it indicates that the trend is shifting upward. This is what is called a ‘golden cross’. And when the shorter-term MA crosses below the longer-term MA, it gives a ‘sell’ signal and that is called a ‘dead/death cross’.
Stock markets can ride new waves or scale walls of worry all in a day’s work, and that is where technical indicators can make a big difference in trading. A moving average (MA) is one of the commonly used technical tools best known as trend following or lagging indicator, because it is based on past prices. Thus, it can only help to confirm when a change takes place in the trend.
When co-related with other technical indicators such as Relative Strength Index (RSI) and Moving Average Convergence Divergence (MACD), an MA can assist in determining ‘buy’ or ‘sell’ signals. The use of multiple moving averages can typically enable traders to opt for a more powerful trading strategy.
(DK Aggarwal is the CMD of SMC Investment and Advisors)