How To Use a Moving Average to Buy Stocks

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How To Use a Moving Average to Buy Stocks

The moving average (MA) is a basic technical analysis technique that smooths out price data by calculating an average price that is continually updated. The average is calculated over a given time period, such as 10 days, 20 minutes, 30 weeks, or any time period selected by the trader. There are benefits to employing a moving average in your trading, as well as many types of moving averages to choose from.

Moving average methods are especially popular because they can be customized to any time period, making them appropriate for both long-term investors and short-term traders.

Key Takeaways

  • A moving average (MA) is a popular technical indicator that smooths out price patterns by removing noise from random short-term price movements.
  • Moving averages may be built in a variety of methods and with varying amounts of days for the averaging period.
  • Moving averages are most often used to predict trend direction and support and resistance levels.
  • When asset prices cross over their moving averages, technical traders may get a trading signal.
  • Moving averages are valuable on their own, but they also serve as the foundation for other technical indicators such as moving average convergence divergence (MACD).

Why Use a Moving Average

A moving average reduces the amount of noise in a price chart. Examine the moving average’s direction to get a sense of which way the price is trending. If it is angled up, the price is likely to be going up (or was recently); slanted down, the price is likely to be heading down; and moving sideways, the price is likely to be in a range.

A moving average may also be used to provide support or resistance. In an uptrend, a 50-day, 100-day, or 200-day moving average, as seen in the picture below, might operate as a support level. This is due to the fact that the average functions as a floor (support), and the price bounces up off of it. A moving average may operate as resistance in a downturn; like a ceiling, the price reaches the level and then begins to fall again.

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Image by Sabrina Jiang © Investopedia2020

The price won’t always respect the moving average in this way. The price may run through it slightly or stop and reverse prior to reaching it.

As a general guideline, if the price is above a moving average, the trend is up. If the price is below a moving average, the trend is down. However, moving averages can have different lengths (discussed shortly), so one MA may indicate an uptrendwhile another MA indicates a downtrend.

Types of Moving Averages

A moving average can be calculated in different ways. A five-day simple moving average (SMA)adds up the five most recent daily closing prices and divides the figure by five to create a new average each day. Each average is connected to the next, creating the singular flowing line.

Another popular type of moving average is the exponential moving average (EMA) (EMA).The calculation is more complex, as it applies more weighting to the most recent prices. If you plot a 50-day SMA and a 50-day EMA on the same chart, you’ll notice that the EMA reacts more quickly to price changes than the SMAdoes,due to the additional weighting on recent price data.

Moving averages are calculated automatically by charting software and trading platforms, so no human math is necessary.

One form of MA is not superior than another. For a time, an EMA may perform better in a stock or financial market, while a SMA may perform better at other periods. The time duration selected for a moving average will also have an impact on its effectiveness (regardless of type).

Image by Sabrina Jiang © Investopedia2020

Moving Average Length

Moving average lengths that are often used include 10, 20, 50, 100, and 200. Depending on the trader’s time horizon, these lengths may be applied to any chart time frame (one minute, daily, weekly, etc.). The time frame or duration of a moving average, often known as the “look back period,” may have a significant impact on its effectiveness.

An MA with a short time frame will respond to price fluctuations significantly faster than an MA with a large look-back period. In the graph below, the 20-day moving average closely reflects the real price more closely than the 100-day moving average.

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A shorter-term trader may gain analytically from the 20-day moving average since it tracks the price more closely and hence causes less lag than the longer-term moving average. A longer-term trader may benefit more from a 100-day moving average.

Lag is the amount of time it takes for a moving average to warn a possible trend reversal. Remember that when the price is above a moving average, the trend is deemed upward. When the price falls below that moving average, it indicates a possible reversal. A moving average of 20 days will produce far more reversal indications than a moving average of 100 days.

A moving average may be of any length: 15, 28, 89, and so on. Changing the moving average to generate more accurate signals on previous data may aid in the creation of better future signals.

Trading Strategies: Crossovers

Crossovers are a popular moving average strategy. The first kind is a price crossover, which occurs when the price crosses above or below a moving average to indicate a possible trend shift.

Image by Sabrina Jiang © Investopedia2020

Another technique is to use two moving averages on a chart, one longer and one shorter. When the shorter-term MA crosses above the longer-term MA, it suggests that the trend is turning upward. This is referred to as a golden cross. Meanwhile, a sell signal is generated when the shorter-term MA crosses below the longer-term MA, indicating that the trend is turning downward. This is referred to as a dead/death cross.

Image by Sabrina Jiang © Investopedia2020

MA Disadvantages

Moving averages are generated using past data, and there is nothing predictive about the method. As a consequence, moving averages might provide erratic outcomes. At times, the market seems to obey MA support/resistance and trade signals, while at other times, it does not.

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One big issue is that choppy price movement may cause the price to bounce back and forth, resulting in many trend reversals or trade signals. When this happens, it’s better to take a step back or use another indication to assist define the pattern. The similar issue may happen with MA crossovers when the MAs get “tangled up” for an extended length of time, resulting in repeated lost transactions.

Moving averages function effectively in strong trending situations but not so well in choppy or ranging settings. Adjusting the time period may temporarily solve this problem, but similar concerns are likely to arise at some point regardless of the time range used for the moving average (s).

The Bottom Line

A moving average smooths out price data and creates a single flowing line. This makes it easy to notice the trend. Exponential moving averages respond to price fluctuations faster than basic moving averages. This may be beneficial in certain circumstances, but it may also result in erroneous signals in others. Moving averages with a shorter look-back duration (for example, 20 days) will also react to price movements faster than averages with a longer look-back period (200 days).

Moving average crossovers are a common entry and exit method. MAs may also show possible locations of support or resistance. While this seems to be predictive, moving averages are always based on previous data and merely display the average price for a certain time period.

Investing using a moving average, or any other approach, requires the opening of an investing account with a stockbroker. The list of the finest online brokers on Investopedia is a wonderful location to start your search for the broker that best meets your demands.

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