Moving Averages
Moving averages simply allow us to define and recognize trends.
Official Terminology
Simple Moving Average (SMA) – The mean of closing prices during a given time period.
Exponential Moving Average (EMA) – Also known has weighted moving average, the EMA is similar to SMA but more weight is given to most recent prices in relation to the time period.
Overall Concept
Unlike support, resistance, and other patterns that are pretty much subjectively inferred, the moving average is a study that allows traders to select a time frame and the output does not vary; however, what traders decide based on the moving average can differ.
Although one can create the time frame of their choice, the more popular ones include 10, 20, and 200 days. The time period used depends on the time frame of the trader. Day traders are more than likely to ignore a 200-day moving average and opt for something smaller such as 10 day moving average.
Most patterns require a combination of different resistance, supports, and other straight lines, which can sometime lead to a wider than desired target. Moving averages are rarely straight lines and allow traders more specific price targets.
It is best to use moving averages only after a current trend or pattern has been established.
SMA vs. EMA – While that actual difference between SMA and EMA is minimal, each one is optimal for different traders and different time frames. EMA tends to respond to movement much faster than SMA because more weight is put on the recent prices; however, sometimes it could overshoot proper targets.
Quick Check: You are a long-term buy and hold trader. Stock X just crossed the 10-day SMA. Is this of any significance to you?
Answer: No, because the crossing of that 10 day moving average is only significant if you are looking for short term or swing trades. If you plan to buy and hold, then longer term moving averages such as the 200 day moving average is more important to you.
Before making any final decisions about support and resistance make sure to check to the moving average that is best suited for your time frame.
Concept in Action
The stock chart above shows the 100-day moving average (blue line) of the stock. While the average was below the current price we saw a constant uptrend. Eventually the stock got in a trading range, which causes the moving average to be useless. Once the average became greater than the price, the stock headed downwards.
The last we see is the stock about to move into another trading range. At this point we would be looking for the moving average to cross back under the price, which it eventually did and the stock headed back up.
Important Notes and Reminders
1. Moving averages are mostly used to determine overall change in trend for a specific time period.
2. Moving averages are an objective study, which creates subjective decisions.
3. Longer your time frame, the longer moving average time frames that should be of importance to you.
4. Use moving averages only after a trend has been established.
5. Moving averages are useful to sort out stocks in scans.