How to buy stocks using moving averages

Moving Average (MA) is a simple technical analysis tool that smooths price data by creating constantly updated average prices. The average is taken from a specific time period, such as 10 days, 20 minutes, 30 weeks, or any time period chosen by the trader. There are advantages to using moving averages in your trading, and you can choose what type of moving averages to use. Moving average strategy is also very popular, can be customized for any time frame, suitable for long-term investors and short-term traders.

Key points

  • Moving Average (MA) is a widely used technical indicator that smoothes price trends by filtering out the “noise” in random short-term price fluctuations.
  • Moving averages can be constructed in several different ways and use different days for the average interval.
  • The most common application of moving averages is to determine the direction of a trend and determine support and resistance levels.
  • When the price of an asset crosses its moving average, it may generate trading signals for technical traders.
  • Although moving averages are useful enough on their own, they also form the basis of other technical indicators, such as moving average convergence divergence (MACD).

Why use moving average

Moving averages help reduce the “noise” on the price chart. Check the direction of the moving average to understand the basic concept of price movements. If it tilts upward, the price is generally rising (or recently); tilts downward, and the price moves downward as a whole; if it is sideways, the price may be within a range.

Moving averages can also be used as support or resistance. In an uptrend, a 50-day, 100-day or 200-day moving average can be used as a support level, as shown in the figure below. This is because the average is like a bottom (support), so the price rebounds from it. In a downtrend, the moving average may act as resistance; like a ceiling, the price reaches a level and then begins to fall again.

Prices will not always “respect” the moving average in this way. The price may pass through it slightly or stop and reverse before reaching it.

As a general rule, if the price is higher than the moving average, the trend is upward. If the price is below the moving average, the trend is downward. However, moving averages can have different lengths (discussed later), so one MA may indicate an uptrend, while another MA indicates a downtrend.

Types of moving averages

Moving averages can be calculated in different ways. The five-day simple moving average (SMA) adds the five most recent daily closing prices and divides by five to create a new daily average. Each average is connected to the next, thus forming a bizarre flow line.

Another popular moving average is the exponential moving average (EMA). The calculation is more complicated because it applies more weight to the most recent price. If you draw a 50-day SMA and a 50-day EMA on the same chart, you will notice that the EMA reacts to price changes faster than the SMA because it has extra weight on the most recent price data.

The chart software and trading platform will do the calculations, so manual calculations are not required to use moving averages.

One type of MA is no better than another. EMA may perform better in stock or financial markets for a period of time, while at other times, SMA may perform better. The time frame chosen for the moving average will also play an important role in its effectiveness (regardless of the type).

Moving average length

Common moving average lengths are 10, 20, 50, 100, and 200. These lengths can be applied to any chart time frame (one minute, daily, weekly, etc.), depending on the trader’s time frame.

The time frame or length you choose for a moving average, also called a “look back period”, can play an important role in its effectiveness.

Compared with MAs with a longer lookback period, MAs with a shorter time frame react much faster to price changes. In the chart below, the 20-day moving average is closer to the actual price than the 100-day moving average.

20 days may have an analytical advantage for short-term traders because it follows prices more closely and therefore produces less “lag” than long-term moving averages. The 100-day moving average may be more beneficial to long-term traders.

Lag is the time required for the moving average to signal a potential reversal. Recall that as a general rule, when the price is above the moving average, the trend is considered upward. Therefore, when the price falls below the moving average, it represents a potential reversal based on the moving average. The 20-day moving average will provide more “reversal” signals than the 100-day moving average.

The moving average can be of any length: 15, 28, 89, etc.Adjust the moving average to provide more accurate historical data signals possible Help create a better future signal.

Trading strategy-crossover

Crossover is one of the main moving average strategies. The first type is price crossovers, where prices cross above or below the moving average to indicate potential changes in the trend.

Another strategy is to apply two moving averages to the chart: one longer and one shorter. When the short-term moving average crosses the long-term moving average, it is a buy signal because it indicates that the trend is moving upwards. This is called the “Golden Cross”.

At the same time, when the short-term MA is lower than the long-term MA, it is a sell signal because it indicates that the trend is moving downward. This is called the “death/death crossover”.

Shortcomings of horses

The moving average is calculated based on historical data, and nothing in the calculation is predictive. Therefore, the result of using a moving average may be random. Sometimes, the market seems to respect MA support/resistance and trading signals, while at other times, it shows that these indicators are not respected.

A major problem is that if the price trend fluctuates, the price may swing back and forth, resulting in multiple trend reversals or trading signals. When this happens, it is best to give in or use another indicator to help clarify the trend. When the MA is “entangled” for a period of time, triggering multiple losing trades, the same thing will happen when the MA crosses.

Moving averages work well under strong trend conditions, but do not work well under volatility or interval conditions. Adjusting the time range can temporarily solve this problem, although at some point, these problems may occur regardless of the time range selected for the moving average.

Bottom line

Moving averages simplify price data by smoothing the price data and creating a flow line. This makes it easier to view trends. Exponential moving averages react faster to price changes than simple moving averages. In some cases, this may be good, while in other cases, it may cause false signals. Moving averages with a shorter lookback period (for example, 20 days) also react faster to price changes than averages with a longer lookback period (200 days).

Moving average crossings are a popular strategy for entering and exiting markets. MA can also highlight potential areas of support or resistance. Although this seems predictive, the moving average is always based on historical data and only shows the average price over a specific period of time.

Investing using moving averages or any technology requires opening an investment account with a stockbroker. InvestingClue’s list of the best online brokers is a good place to start researching the broker that best suits your needs.

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