How to Use a Moving Average to Buy Stocks

What are Moving Averages?

The moving average (MA) is a simple technical analysis method that creates a continuously updated average price to smooth out price data. The average is calculated over a predetermined time frame, such as ten days, twenty minutes, thirty weeks, or any other time frame the trader specifies. There are several benefits to employing a moving average in trading, and there are many moving average types to choose from.

Moving average methods are more prevalent among traders and can be adjusted for any time frame, making them suitable for both long- and short-term traders. These averages mainly help traders track the market movements for a specific period of time in the past and plan strategies for the future.

Why do investors and analysts use a Moving Average?

In general, MA's are commonly used to smooth out price trends by reducing the noise from volatile short-term price movements, and on the price chart, a moving average also helps analyse price trends of the past. To gain a general picture of the price movement, one can examine the direction of the moving average. If the angle is upward, the price is moving upward (or was, recently); if it is downward, the price is moving downward; if it is sideways, the price is likely in a range.

Moving averages can also serve as support or resistance. As believed by analysts, a 50-day, 100-day, or 200-day moving average may function as a support level during an upswing. This is due to the average floor-like (supportive) behaviour, which causes the price to rise. A moving average may serve as resistance during a downtrend; like a ceiling, the price may reach the point before beginning to decline again.

The price will not always adhere to the moving average in this manner. Before it is reached, the price may pass just slightly through it or halt and reverse.

Generally speaking, a price above that of a moving average indicates an upward trend, and a price below a moving average indicates a downward trend. Moving averages, on the other hand, come in a variety of lengths (explained in more detail below), so one MA can imply an uptrend, while another MA might indicate a downturn. However, this approach is not completely reliable as it is based on the assumptions of past data.

Types of Moving Averages

There are numerous methods for calculating a moving average. A five-day simple moving average (SMA) calculates a new average each day by adding the five most recent daily closing prices and dividing the total by five. The single flowing line is made up of successive averages that are connected to one another.

The exponential moving average (EMA) is a well-known variety of moving averages. Since the most current prices are given more weight in the computation, it is more complicated. Because of the additional weight given to current price data, the EMA responds to price fluctuations more swiftly than the SMA does if a 50-day SMA and 50-day EMA are plotted on the same chart.

Using a moving average doesn't require manual calculation because charting tools and trading platforms do the computations. There is no better MA than another. In the stock or financial markets, there may be periods when an EMA performs better than an SMA and vice versa. A moving average's effectiveness will also be significantly influenced by the selected time frame (regardless of type).

Moving Average Length

Moving averages with lengths of 10, 20, 50, 100, and 200 days are typical. Based on the trader's time horizon, these lengths can be used with any chart time frame (such as the one-minute, hourly, daily, etc.). The "look back period", often known as the length of a moving average, can have a significant impact on its performance.

Compared to an MA with a large look-back period, one with a short time frame will respond to price fluctuations more quickly. Compared to the 100-day moving average, the 20-day moving average more nearly reflects the real price.

Due to its closing price tracking and hence lower lag than the longer-term moving average, the 20-day may be analytically advantageous to a trader who trades on a shorter time frame. The longer-term trader would benefit more from a 100-day MA.

The amount of time a moving average needs to identify a likely reversal is known as lag. Remember that the trend is often regarded as upward when the price is greater than a moving average.

A potential reversal is therefore indicated when the price falls below that MA. Compared to a 100-day MA, a 20-day moving average would show many more reversal signs.

Any length-15, 28, 89, etc.-can be used for moving averages. It might be possible to improve future signals by modifying the moving average to produce more precise signals based on prior data.

Trading Strategies: Crossovers

One of the primary moving average techniques is the use of crossovers. The price crossing above or below a MA to indicate a potential trend change is known as a price crossover.

Another technique uses two moving averages-one longer and one shorter-to analyse a chart. It is a buy signal when the shorter-term moving average rises above the longer-term MA since it shows that the trend is moving upward. Conversely, a sell signal is generated when the shorter-term moving average falls below the longer-term MA, pointing to a downward trend.

MA Disadvantages

Moving averages are calculated using past data and therefore have no predictive characteristics. As a result, outcomes from utilising moving averages may be arbitrary. The market sometimes appears to obey MA support/resistance levels and trade signals, and other times it doesn't.

One significant issue is the possibility of several trend reversals or trade signals if the price movement becomes noisy. When this happens, it's better to take a break or use a different indicator to assist in defining the trend. When the MAs become tangled up for a while, it might happen the same way with MA crossings, leading to several losing trades.

Moving averages perform better when there is a strong trend present, but they perform much worse when there are noisy or ranging situations. Although this issue can be temporarily fixed by changing the period, it is likely that the same problems will eventually arise regardless of the moving average's time durations.

Bottom Line

Price data is made easier by a moving average by being smoothed out and forming a continuous line. This facilitates identifying the trend. Simple moving averages take longer to respond to price fluctuations than exponential moving averages. This might be advantageous in some situations, but it might also send out false signals. Additionally, MAs with a shorter look-back time will react to price movements more quickly than averages with longer look-back periods.

MA crossovers are a common approach for both entry and exit. MAs can also identify regions of possible support or resistance. Even though it might seem predictive, MAs always use previous data and simply display the average price over a certain time frame. The approach is not based on a proven strategy or formula.

Note: The financial markets are subjected to risk. Invest or trade with the appropriate technical and fundamental knowledge. One should do proper research or consult their financial adviser.