Moving averages are very popular among beginning traders and investors. They are simple to use and give very easy indicators to buy/sell a stock. The 200-day moving average is generally the most talked about along with the 50-day moving average.
I have both on my charts at all time and use them mainly for trend trading and confirmation. For me, they are a quick visual check on my market analysis and have been a really great tool for me trading at home.
What Are Moving Averages (MA)?
Simply put they average the price data from a stock or ETF. The 200-day MA will take the last 200 days worth of data and, you guessed it, average it out. The 50-day MA will only take the last 50 days and so on. Pretty simple right?
As the market moves, these average also move. New daily prices and added in and old ones are dropped out - 1 day at a time. Moving averages help smooth price action and filter out the noise. They also form the building blocks for many other technical indicators and overlays, such as Bollinger Bands, MACD and the McClellan Oscillator.
The two most popular types of moving averages are the Simple Moving Average (SMA) and the Exponential Moving Average (EMA).
MA's Experience Market Lag
Moving averages do not predict price direction, but rather define the current direction with a lag. Moving averages lag because they are based on past prices - which is mainly why the are not a great short term trading indicator.
The longer the moving average, the more the lag it will have in relation to the current market's movement. For example, a 10-day MA will react quickly to market spikes and drops. In contrast, the 50-day MA and the 200-day MA contains a lot of historical prices and therefore will take longer to turn and adjust.
This is why we don't use them for trading entries and exits. Notice the name of this post - TREND TRADING. Moving averages are slow but great at identifying the overall trend and long term direction of the market.
Use Shorter Time Frames For Short Term Trading
I said before that I don't use MA for short term trading - but you obviously could if you wanted to. If you want to use short moving averages (5-15 periods) you can get quick trading signals on short-term trends. But as always, be careful to check other indicators and support/resistance levels. Don't rely solely on the MA as you only signal to trade.
Moving Average Trend Signal: Cross
There are two different ways moving averages can give you a buy or sell signal:
- Simple Cross - The stock simple crossed above or below the moving average line you are using.
- MA Cross - Two moving averages are used and the shorter term MA crosses above or below the longer term MA.
The direction of the moving average also conveys some important information about prices and the overall market trend. A rising moving average shows that prices are generally increasing. A falling moving average indicates that prices are generally falling.
EMA or SMA?
A big debate that most technical traders have is whether to use an Exponential or Simple Moving Average. I can write down positives and negatives for both, but I'm curious what YOU all like to use and why? Debate this issue by commenting.