By: Chris Rowe — July 31, 2020
This Tool Is a Technical Trader's "Bread and Butter"
Today, let's talk about every technical trader's "bread and butter."
Moving averages are lines plotted on a chart that smooth out data and make it easy to spot trends.
Smoothing the data is helpful because it reduces the noise created by daily market volatility.
Identifying trends is at the heart of technical analysis and is the basis for practically all trading decisions.
Most professional traders watch moving averages to identify support levels during bull markets and resistance levels during bear markets.
There are a number of different moving averages out there. But two of the most popular types are the Simple Moving Average (SMA) and the Exponential Moving Average (EMA).
The Simple Moving Average is the average price of a security over a number of time periods (days, weeks, months, etc.). A 50-day moving average would take the sum of the last 50 days’ worth of closing prices and divide that number by 50.
The Exponential Moving Average reduces the lag in simple moving averages by applying more weight to the more recent price data. Therefore, it reacts more quickly to the recent price changes.
Notice below, in this old chart of Medarex (MEDX), the difference between the 50-day EMA and the 50-day SMA.
The EMA more closely tracks the movement of Medarex and is more volatile than the SMA. Below, you can see that the 50-day EMA (green) is at about $15.60 and the 50-day SMA (red) is at about $15.05.
It’s a matter of personal preference, but I choose to use the Exponential Moving Average because I find that it makes a much more effective indicator, and I can spot trend changes more quickly.
Use Moving Averages to Track Trends and Momentum
Why use anything other than trend lines to spot trends?
Support and resistance levels are useful technical tools, but they shouldn't be used as stand-alone indicators because sometimes they give false signals.
Stocks have the capability of overshooting trend lines. In some cases, we even give trend lines (especially long-term trend lines) leeway using price filters or time filters to avoid “whipsaws.”
Sometimes, using moving averages makes more sense than using trend lines, as moving averages aren't straight lines and adjust to the recent volatility of a security or index.
Like trend lines, moving averages also act as support and resistance because of the self-fulfilling prophecy caused by all other traders who view them the same way.
In fact, you can make the case that moving averages actually cause prices to move more than trend lines do. I say this because trend line analysis can be somewhat subjective, as people can interpret trends differently.
Moving averages cannot be disputed. They're simply a mathematical equation. Therefore, it is possible to enter signals, based on moving averages, into computer programs that automatically trade stocks.
Therefore, when stocks violate, or bounce off of popular moving averages, there are often a heck of a lot of computers out there automatically buying or selling that stock.
The moving averages that you choose to use to guide you in and out of positions depend on your personal trading style and preferred time frame.
But don’t forget that you should always identify, and trade, in the direction of the next larger trend, and that you should identify the next smaller trend to help with more precise timing of your trades.
We'll have more to say about moving averages in future columns.
Founder, True Market Insiders