Looking at a share price chart can be confusing with so many spikes up and down – it can be difficult to know which way a price is moving. That’s where moving averages come in. They can help you to visually see the average price and which way it’s moving in.
SIMPLE MOVING AVERAGE
If you cast your mind to GCSE/high school maths, you’ll remember how to work out an average. Basically add a few numbers, then divide by the number of numbers you added – this gives you the average. The simple moving average works in the same way.
Luckily enough with the wonders of technology and online trading platforms you’ll never need to work this out and plot the results on a graph yourself. I however find it useful to know how tools are constructed so you know what you’re using and what it’s showing you.
All you need to do is tell the software/website what simple moving average you want. There will usually be options like MA 5, MA 10, MA 20, MA 50, etc or it may even let you plug in a number. The number corresponds to the number of values you want to include. So if you are looking at a graph in days, a MA 5 means it will plot the average based on 5 values. Example 4 below shows what I mean – the price on the 28/4/2014 is 0.90 but the simple moving average is 1.26.
Example 1 – Simple Moving Average Calculation.
Exponential Moving Average
The exponential moving average is slightly more complex to calculate (again you’ll never have to do this), but the difference between this and the simple moving average is that it applies more weight/relevance to the more recent prices than the older ones. This makes sense in theory as if you’re looking at a 200 day moving average, you may feel that the more recent prices are more relevant to you than those more than half a year ago.
I’m not going to bore you with the formula on how to do this but I do suggest you have a read here and spend a little time to get your head round it – if you’re like me and not a maths wiz, it may take a little time!
HOW MOVING AVERAGES CAN HELP YOU TRADE
Whether you are using simple, exponential or any other type of moving average in your trading, how they can help you stays the same.
TRENDS
Like with trend lines, moving averages which are pointing up mean that the average price is rising and conversely it’s moving down if the average is pointing downwards. The difference is that with short time frames, the moving average should show you short term trends whilst the longer time frames will highlight longer term trends. Example 5 below shows both the 250 day exponential day moving average and the 50 day exponential moving average for the FTSE 100 for the past 6 months
Example 2 – Exponential Moving Averages. Graph Source: ADVFN.
You’ll notice that the 250 day exponential moving average is less affected by the large spikes up and down and smooths the overall long term trend. The 50 day exponential moving average on the other hand reacts quicker to the spikes either way giving you the ability to look at long term and shorter term trends at a glance.
REVERSALS
Moving averages can help you with identifying a reversal in trends. If the moving average begins to point down, it could be showing you that the price is beginning a downward trend. This can help you to identify when to go short (I’ll explain this term in future posts) or look to potentially sell a position you are in. A key indicator is when a short term moving average crosses a longer term one and the longer term moving average begins to point down. Looking at example 6 you can see where the short term moving averages crosses the longer term moving average, which then begins to point down. If you were an investor you may be wary in investing for the longer term at this point. Remember that moving averages have a time delay so the longer the average is, the longer it will take to be affected by price fluctuations.
Example 3 – Reversal. Graph Source: ADVFN
SUPPORT AND RESISTANCE
Moving averages like trend lines can provide levels of support and resistance. When a share is trending up or down you can at times see it bouncing off the moving average, which can give confidence that the moving average at this point in time is providing support or resistance.
Example 4 – Moving Average Support and Resistance. Graph Source: ADVFN
Example 7 above shows how the longer term trend seems to support the FTSE 100 from the start of the graph to at least around July time. Conversely in late November after a sharp downturn the 250 day exponential moving average proves to be resistance and the price falls away again after having risen to it.
TIPS WHEN USING MOVING AVERAGES:
Look at more than one length of moving average, it’s always useful to see what the long and short term trends are. Remember that just because a particular moving average provides support to one stock, doesn’t mean it will have the same effect on another. It’s a safer bet to buy a stock near the moving average rather than when it is far above it. It’s a safer bet to buy a stock when the moving average is pointing up! (Why buy something when it’s going down?)Like trend lines, a moving average when broken down, can flip to resistance like in example 7.Try to avoid plotting all the averages available to you on screen at once. This just gets confusing and counter productive. Play around and keep a couple that work for you and your trading style. Moving averages are worked out on historical prices. So any time frame you view, however short, is always looking at the past! This means don’t expect that whatever has happened in the past will happen again. ROUND UP
Remember that following signals or trading techniques blindly can be folly as that essentially amounts to gambling and hoping for the best. That’s something you want to avoid if you want to keep your money in your pocket!
Like with most things in life, keeping things simple is usually a winner. As mentioned before there is a plethora of technical analysis out there, but for me it’s about finding what works for me and using it as effectively as possible.
On the other hand, like many others, you may feel that it’s all gobbledygook and not useful at all! You’ll have to make up your own mind on this!
