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.
What is Moving Average?
In statistics, moving average basically divided a data set into subsets following which it finds the mean of each of those subsets in order to filter out the excess fluctuations and instead find out the general trend over a range i.e. a period of time. In stock market jargon, 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.
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.
Example: What is Simple Moving Average ?
Simple Moving Average is an analytic tool. A Simple Moving Average aims to crunch past data into a single number to hide short-term volatility and gives traders an idea of the emerging trend. In other words, a Simple Moving Average helps traders get the signal from the noise. Below, we will understand what SMA is in trading.
Tracking every minute change in the stock price may not be very useful for all traders. Therefore, traders use the Simple Moving Average to collapse a high volume of data into a single figure. Let’s understand how this is done by looking at the Simple Moving Average definition.
Most people are familiar with the term average, or mean. To calculate the average of ten numbers, we simply add all the ten numbers and divide the sum by ten. That will give us the average.
March 1st to March 10th of 2020 were a volatile 10 days for the stock market. If you want to cut through the volatility, you can add up the closing prices of all ten days and divide by 10. But to cut through the noise better, you can use a moving average. To calculate the moving average, find the average closing price from March 2nd to march 11th, march 3rd to march 12th, and so on. The graph line that will connect all these averages (that are moving across time) is called the moving average.
A Simple Moving Average is simply a moving average that gives equal weight to all the units in the range. A Simple Moving Average can be understood with greater clarity in comparison with an exponential moving average. We will break down the difference in the last section of the article.
How to calculate simple moving average
To calculate the Simple Moving Average, one must pick a range. 10 day SMA and 50 day SMA are quite regularly used by traders. Once the trader has picked a range, he needs to pick a time period whose Simple Moving Average he wishes to know. After the time period has been selected, the moving averages inside the selected range must be calculated, and plotted on a graph.
If the range is 10 days, like our example above, then the trader needs to figure out the moving averages of 10-day blocks. Once the moving averages have been plotted on a graph, a simple line can be drawn to connect the dots. That line is the Simple Moving Average. The direction and momentum of this line can give the trader insights that can inform his investing choices.
Short term SMA v/s Long-term SMA
A 200 day Simple Moving Average will be called a Long-term SMA, while a 50 day moving average will be called a Short-Term SMA. The relationship between short term SMAs and Long-term SMAs can reveal emerging trends as well.
For instance, if the Short-term SMA dips below Long-term SMA, then that could be an indication of a coming bear run. In the financial market parlance, this is known as a Death Cross.
If the opposite happens – that is, if the short-term SMA cuts through and rises above long-term SMA – then that could indicate a coming bull run. In the financial market parlance, this is known as a Golden Cross. Traders often chose to buy the stock whose prices show a golden cross as it indicates possible positive movement of stock prices in the near-future.
Variations to SMA
Weighted moving averages are a variation of Simple Moving Averages. Simple Moving Averages have an analytic flaw, which is that they assign equal value to each unit in the range. That is, in a 200 day SMA, the stock prices from 200 days ago will be assigned the same weight(weight as in mathematical significance) as the stock prices from yesterday. Certain traders look at this, and rightfully argue that recent stock prices should be considered more significant than prices from months ago. These traders prefer to use weighted moving averages, that give greater weightage to more recent values in the range.
Exponential Moving Averages are an example of weighted moving averages. EMAs give exponentially more weightage to stock prices as they get closer to the date of calculation.
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.