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Outline of today’s lesson, we will be covering:
- Optional explanation of how moving averages work
- Period of moving averages
- Using moving averages in your strategy
- What do the difference in days mean
- Limitations of moving averages
- How to add moving averages to charts
- Exponential moving averages (EMA)
- Sum up the lesson
A moving average is an indicator that smooths out the day to day price movement to show you the general direction the stock is moving towards.
(Here is an optional explanation of how it works)
A moving average works by using the closing prices for a period of days divided by the number of days itself, to give you the line that is the moving average.
For example, a moving average of 3 will use the closing prices of the last 3 days.
In the picture, a 3-day moving average on Day C will be calculated as day A + day B + day C = 13.
The value you get is a point on the moving average and the values from all the days will be calculated. A curve will then be drawn through all this points to give you the moving average.
Period of moving averages
A moving average with a period of 10 means it will use the last 10 days to calculate the moving average. The period refers to the number of days that moving average will be based on.
A moving average with a period of 20 will use the last 20 days.
The shorter the period of your moving average, the more sensitive it will be to price movements.
Using moving averages in your strategy
Moving averages can be used as a guide to determine the presence of a trend. They can also be used to help you enter or exit a trend. Here are 3 ways to use MAs.
- Crossovers (bullish & bearish cross)
You can use 2 moving averages of different periods to generate bullish or bearish signals. When the shorter MA crosses above the longer MA, it is a positive signal that the stock is moving up. When the shorter MA crosses below the longer MA, it is a negative signal that the stock is moving down.
- Shorter MA crosses above the longer MA = bullish cross
- Shorter MA crosses below the longer MA = bearish cross
An example is to use 2 different MA, one moving average has a period of 25, another has a period of 50. When 25 is above 50, the stock is bullish. When 25 is below 50, the stock is bearish. You can use this to generate entry and exit signals.
- Using MAs in pairs or triples
Having learnt about bullish and bearish crosses, we can now use them in pairs. One way to do it is by having a pair of MA for the short term and another pair for the long term. When a trend is changing, the short term MA will always react faster than the long term MA. Thus we can use the short term pair as the 1st signal and the long term pair as the confirmation signal.
Examples are 20 & 40 for the short term and 50 & 100 for the long term.
You can also use MA in triples. You could use periods of 15, 50, 150. The shortest MA will always react fastest to price action. For example at the start of an uptrend:
- 15 crosses above 50 (1st signal)
- 15 crosses above 150 (2nd signal)
- 50 cross above 150 (confirmation)
This is another method showing how versatile moving averages are.
- Enter only when the price is close to the moving average
As a stock moves up or down, they never move directly up or down. There are dips and peaks as a stock moves. This is because investors are constantly selling or buying new positions, thus you get the pullbacks(uptrend) and throwbacks(downtrend).
One thing you could use MA is to help you reduce your risk when you enter a stock. It is best to enter when the stock is near the moving average as the stock will always tend to retrace to the MA as it move. This is due to the normal ebb and flow of the market.
What do the differences in days mean?
Changing the days will change the sensitivity of the MA. The shorter the period, the more sensitive the MA is.
Some popular periods that investors like to use for moving averages are
- 150, 200 day (Long term)
- 50, 100 day (Med term)
- 20, 40 day (Short term)
These are just guidelines as the days are up to your own preference. It also depends on the timeframe that you intend to invest for. Some people would use 50 as their short term and 150 as their med term MA. Others will decide to use the 15 & 30 day as their short term MA.
Ultimately you have to try it yourself to see which period fits your strategy best. Even adjusting the periods to a 33 day and 67 day MA will be fine. This slight difference in the periods should not affect your returns because moving averages are just one portion of your entire strategy.
Limitations of moving averages
Moving averages work best in a trending market, because they are trend following indicators. If used in a sideways market, they will provide a lot of false signals.
Using MA also means you will miss the start of a trend as you have to wait for the signal from the moving average will only come when the trend is established. This might cause you to miss out on some of the early profits from the trend.
How to add MA into charts
To add moving averages to your chart, look for the “indicator” button. Then choose the period for your moving average.
Exponential moving averages (EMA)
When you choose a moving average, there is a simple moving average and an exponential moving average. The difference between the SMA and EMA is, every period in the SMA is equal and carries the same weight. But for the EMA, the most recent periods will have a heavier weightage in the moving average.
To put it simply, the EMA is more responsive to recent price changes compared to the SMA.
You can experiment on your own and decide which kind of moving average you prefer, one is not necessary better than the other.
To Sum up this lesson
- A moving average is an indicator that shows you the general direction a stock is moving towards.
- The period of a moving average refers to the number of days of the moving average.
- The shorter the period, the more sensitive a moving average will be.
- A bullish cross by the moving average occurs when the shorter moving average crosses above the longer moving average.
- A bearish cross by the moving average occurs when the shorter moving average crosses below the longer moving average.
- Moving averages can be used in pairs or triples.
- It is best to enter a stock only when the price is near the moving average, to reduce your risk.
- Moving averages should be used with other tools in your strategy to increase your odds of success.
- Moving averages work best in a trending market and can provide a lot of false signals in a sideways market.
- The difference between a SMA and an EMA is the EMA is more sensitive to recent price changes.
More info for those who are interested
Moving averages can also be used as support and resistance, here is an article illustrating this.