7. Using moving averages

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Stock trading requires you to make use of profit opportunities that emerge from the way prices move. Traders use specific technical indicators to study price movement and opportunities that arise from them. One of the most popular and reliable technical indicators is the moving average. It is the average of the closing prices over the given period. The averaging out helps smoothen the price information and distil the noise of daily price changes.

There are short term moving averages like the 10-day moving averages or 7-day moving averages or long term moving averages like 200-day moving averages. A 200-day moving average, for example, is the average of closing prices of the last 200 trading days. All these are quite useful for indicating price trends and providing a trend line to place potential support and resistance.

How is moving average calculated?

The formula for moving average is:

MA = (SP1+SP2+SP3+SP4+SP5)/5

Here, SP = Stock Price.

Let’s take the example of stock X.

In the past five trading days, the closing prices of the stock are as follows:

Day

Stock price

Day 1

50.50

Day 2

50.45

Day 3

50.60

Day 4

50.05

Day 5

50.80

In this example, the moving average of the stock price would be:

MA = (50.50+50.45+50.60+50.05+50.80)/5

MA = 252.4/5 = 50.48

Hence, the moving average of the stock price is 50.48.

Application of Moving Averages

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.

Removes Impact of Daily Price Fluctuations

Moving averages remove the chaos of daily fluctuations in prices from the stock chart. On the price chart, it looks like a trend line, giving the trader a quick glimpse of the price trend.

Direction of prices

If it is an upward trending moving average, prices are likely on the rise, but if it is a sharp uptrend, then prices might be peaking. If it is a downtrend, prices are on a decline. A sharp downward slope, however, may indicate prices have bottomed out.

A trend line moving sideways indicates a range-bound movement in prices.  Usually, when real-time prices are above the moving average (MA), it signals an uptrend, and when prices are below the MA, you will see prices being pulled in the downward direction. Two moving averages of different durations may merge and cross each other in opposite directions, as will see later.

How to Use a Moving Average to Buy Stocks: Support or Resistance Level

Medium to long term moving averages like 50-day or 200-day ones double up as popular and reliable support and resistance levels. These points on the moving average are relatively challenging to breach. That makes it more effective as a signal to buy or sell a stock when prices touch the support and resistance levels. In a trending market, prices move within a range. They usually bounce off the support level on moving averages or pull back from grazing the resistance level. These levels are again only breached with sufficient buyers or sellers coming in. This allows for a reasonable holding period.

Moving Average Crossover Trading Strategies

50-day moving average of BSE Sensex (purple) crosses over its 200-day moving average (yellow).

In one of the popular trading strategies, traders use a combination of short-term moving averages like 50 days and long-term ones like 200 days as trend indicators to test the bullishness of the stock.

Like you see in the price chart of BSE Sensex above, if a stock’s 50-day MA jumps over a 200-day MA, it is called a Golden Cross in stocks. It signals a bullish turn in sentiment. Here, you will also find the shares touching the support levels on the long-term moving average, indicating that prices may have bottomed out.

Wrapping up

Moving averages have often been criticised for having a lag effect. That is, they show a trend based on past prices. But they serve few important purposes of distilling daily price changes for a smoother indication, offering strong and reliable levels of support and resistance. Understanding how to use moving averages is useful for traders to enter in and buy stocks or take short positions.

A Quick Recap

  • The most common applications of moving averages are to identify trend direction and to determine support and resistance levels.
  • When asset prices cross over their moving averages, it may generate a trading signal for technical traders.
  • While moving averages are useful enough on their own, they also form the basis for other technical indicators such as the moving average convergence divergence (MACD).
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