Moving Averages
A moving average is the sum of whatever you’re examining. In this case, I’m talking about the closing prices of a stock. For example, a 20–, 30–, 50–, 100–, or 200-day moving average is then divided by the total number of days, resulting in the average price of the stock. A 30-day period is commonly used for short-term buy and sell signals.
As stocks move above the 30-day moving average, it’s said that the stock has greater upside potential; and, as the price drops down below the 30-day moving average it’s said that the stock has greater odds of moving lower at that time. Such moving averages are helpful when determining levels of support and resistance. As a habit, I have found that once a stock drops below the 30-day moving average, it may be best to place a stop loss order at a select price. I’ll talk more about this later 9 as I go into the details using the Average True Range (ATR) indicator.
Also keep in mind that of all the various moving averages, the 200- day moving average results in the strongest moving average. This is simply because it is referred to as being a major point of support or resistance for either stocks or Indexes.
Moving Averages Examined
Below is a good example of how to compute a moving average. By adding the closing prices of this stock over the last 7 days, you get $393.93. Divide that result by the 7 days because each one of those numbers represents 1 day. That process results in the average price of the stock—$56.27.Example: $56.06 + $59.31 + $56 + $55.56+ $56 + $57 and $56.26 = $393.93 Now divide$393.93 by 7 (total number of days)= $56.27 average price.
The first thing to remember about a moving average is not its precise total—but what that total represents. Whichever moving average you’re looking at, its total represents the price of that stock over that time frame. So if I’m looking at a 7-day moving average, and I’ve got $56.27, that tells me that the average price of the stock over the last 7 days was $56.27—because that’s the parameter I was using.
Stay focused on the fact that a moving average represents the price of a stock within a certain period. So when using such moving averages as the 30 or even the 200, it’s telling you what the average price is for that given time frame.
Looking Back on Moving Averages circa the 1990s
Moving averages have become extremely popular again. I remember in 1997, ‘98, and ‘99, the only moving averages people were looking at were 10s and 20s, maybe 30s. The 200-day moving average was so far away from the actual current price of the stock, no one could locate it. Everyone now looks at 200-day moving averages as the strongest point of support or resistance because stocks continue to change directions. So a 200-day moving average is taking a major toll in the actual evaluation of a stock.
Two Main Types of Moving Averages
There are two primary types of moving averages:- Simple moving averages include less of a reaction, allowing for a slower or more effective signal.
- Exponential moving averages create more of a reaction, causing a faster and less effective signal.
Now you’re saying to yourself—why should a shorter moving aver- age and faster movement be important to me? A good question: if you’re in a bullish position
If you find yourself in a bullish position with the market beginning to change course, consider shortening your moving average-which will result in a quicker sell-signal.or long in the stock (or maybe just the option), you should probably consider shortening your moving average. Don’t keep the moving average the same. If you’re using a 30- or 40- day moving average, it’s going to take 30 or 40 days before you actually begin getting a sell signal. So by all means, shorten some of those averages!
Which Moving Average To Rely On?
Now that we’ve covered the differences between simple and exponential moving averages, I will tell you that I almost always use a simple moving average, except with two different indicators. My reason for this is simple: I’ve found that the exponential moving average with those two indicators works best. And I’ve back-tested every approach I refer to for a minimum of 6 months before applying it to real money.
FIGURE 1
These days, people are using shorter moving averages ranging from 10 to 30 days. Why? Because shorter moving averages help investors identify both when to get into or out of a stock sooner rather than later.
A chart on moving averages is shown in Figure 1. Though there are four averages here, I’m going to focus on the two larger ones, the 10- and 20- day. Never go long or short unless these moving averages cross. If you go directly up in the chart, you have a cross on these moving averages. When you see the 10-day break down through the 20-day, it would be a short opportunity or a sign of weakness in the stock. If it were the reverse, it would be a buy opportunity or a sign of strength as the 10-day moving average moved up through the 20-day moving average.
Moving Average Time Target: 3 Days
Another factor that you should consider with this moving average is consecutive days. In this example, you should see a specific aver- age confirmed over at least 3 consecutive days, primarily because there was a crossover of the moving averages.The more pluses your chart shows, the more positive the outlook.What you see in Figure 1 is a simple 10- and 20-day moving average. This is resulting in a short (down- ward investment) opportunity,
right? Not necessarily. I use a 12-plus system, and this is how I’ve set it up. There are 12 tabs on my charting system. I start by putting the least effective one in tab 1 and the most effective one in tab 12. By the time I go through 1 to 12, if I have more pluses than minuses, I consider taking on the position. You can use various types of technical programs to create your own 12 plus scenario. You may even utilize your most rewarding technical indicators by adding them all on one chart so you can view them at the same time.
If Figure 1 were tab 1, I would say that so far, this would be a plus (assuming I wanted to short it).The 10-day has crossed through the 20-day, which is a better signal in this case, and the stock should move lower. But as I said, I would also wait 3 days to see how the trade actually falls out before making a final determination.
Another important consideration in this case is the 200-day moving average. As I discussed at the beginning of this article, the 200-day moving average is still the strongest point of support. Although this stock’s moving averages are crossed, the fact remains that it’s coming down, testing its strongest point of support—so I would still be patient. Wait for it. Get another confirmation.
Be sure to avoid trading a stock before it comes down far enough to test its strongest point of support, which would be what we refer to as a better confirmation of taking on the trade.Once it finally breaks down, I’d have better odds of increasing my return, or at the least, losing less money. Yet another interesting occurrence in a picture like this is when you have
a gap up or down (see Figure 2). A gap up or down is a sign of strength or weakness. When stocks gap up, the price moved higher
FIGURE 2
prior to the open of the market; and, when stocks gap down, the price moved lower prior to the market open. This is simply a sign of good (gap up) or bad (gap down) news taking place and the stock market adjusting the price before the open. Stocks that gap up often move higher, yet stocks that gap down often move down much more than stocks that gap up.
So far, we’ve looked at moving averages crossing each other. We’ve waited 3 consecutive days for the stock to follow that current trend. Then we’ve looked for it to test the moving average. Here, it broke below the moving average and also had a gap down. There’s a better signal of weakness.
Moving over to the right side of the chart, it says never go long or short unless these moving averages cross.
Yet as you can see in Figure 1, they started to cross. We could have waited 3 days, and then have entered the trade at that point. But we would have gotten out rather fast because we then saw another crossover. We’ve started off simply by looking at moving averages, the 10- and 20-day. We’re going to add more indicators as we move forward and create a system similar to my 12-plus system, which will tell us when we should and shouldn’t buy.
Some investors detect early signs of breakouts by adding moving averagesto volumes.
You’ll often find that investors will add a moving average to the volume to alert them when the volume has increased above its daily average (Figure 2). This can be an early sign of a positive or a negative breakout. The moving average time frames will vary with each investor’s objectives and the market conditions.
Laws of Supply and Demand
You already know that the stock market moves simply based on two things: supply and demand. Together, supply and demand are nothing more than volume. If I have a basket loaded with green and yellow bananas, I have a supply of a product to sell. The demand is determined based on how many green or yellow bananas people want to buy. If green sells quicker than yellow, there will be less supply and more demand for the green bananas. Prices will react accordingly—the price of green bananas in this case will rise to meet the high demand and low supply situation.When we start getting more supply and demand, we see the market do one of two things. Obviously, when there’s more supply of some- thing, we talk about it. On the other hand, if no one wants to buy anything, the stock isn’t going to do anything. But if everyone wants to buy something, the stock will go up.
Supply and demand is none other than volume.Let’s take Apple Computers’ ipod as an example; so much demand caused
the increase of the price. As the interest dropped, so did the price. Another great example of this is real estate value; as interest rates drop, more people can afford to purchase homes, which will then drive the values up. As interest rates increase, the demand for homes drops, and so does the value. It is simply a world of supply and demand—the more we want something, the higher the price. The less of something we want, the lower the price will go.
In the chart shown in Figure 2, we added a 20-day moving average to the volume. This way we can identify when the volume is moving above its averages. Often, stocks that are trending upwards don’t need volume unless they are testing levels of resistance. In fact, stocks that are dropping in value truly don’t need volume either; however, many times stocks that are trending sideways need volume to push them up or down. And as I referenced before, I like to see a stock’s daily volume increase 1 ½ times more than the stock’s average volume over the past 20 days. This is a sign of commitment and will increase the stock’s odds of moving, which in return, will increase your odds of success.
So to start, I’ll tell you that we’re using the same stock that we considered previously. As we look at the vertical line, we see the same time frame we looked at for the short—where we had a gap down and a crossover in moving averages. But look at what begins to happen to the volume after 5 months: all of a sudden, we start to see an increase in volume. Increased volume will help push your stock in the direction it is going; and, the more volume, the bigger the movement will be.
If I’m on to tab 2 of my 12-plus system, I’m now getting another plus, because volume is increasing and the trend is continuing to move down. In summary, we’re adding moving averages to our volume; and, as the volume bars begin to increase above the average volume (past 20-day), we’re able to see early signs of buying or selling. This will help us determine a sooner and often a better entry or exit point. As the saying goes “timing” is the most important part of being a successful trader. It’s always best to get in early and get out early.
Article Summary
- A moving average is the average of a stock’s closing prices over a defined period.
- The first thing to remember about a moving average is not its precise total—but what that total represents.
- A moving average represents the price of a stock within a certain period.
- There are two types of moving averages: simple and exponential.
- The shorter the moving average, the faster the movement will be—and vice-versa.
- You should confirm a moving average over at least 3 consecutive days before acting on it.
- The 200-day moving average remains the strongest point of support or resistance.
- A bullish position in a changing market means that you should consider shortening your moving average, resulting in a quicker sell-signal.
Self-test questions
- Which is the strongest moving average?
- 20-day
- 50-day
- 100-day
- 200-day
- Is the 5-day moving average for the following closing prices: 8.5, 10, 10.5, 7 and 9?
- 8.5
- 9
- 9.5
- 10
- Which is the fastest moving average?
- 200-day moving average
- 100-day exponential moving average
- 3-day exponential moving average
- 3-day moving average.
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When using moving averages, when is a buy signal confirmed?
- When the faster moving average crosses over the slower one
- When the faster moving average crosses below the slower one
- Three days after the faster moving average crosses over the slower moving average
- Three days after the faster moving averages crosses below the slower moving average
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What is the law of supply and demand?
- Volume
- As the supply of the stock’s underlying product increases, the demand for the stock increases and the price rises
- The lower the supply of a stock, the lower the price goes
- Buy signals
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What are further confirmations of a moving average crossover?
- 3 days without reversing
- Volume
- A changing market
- The 200-day EMA
- If you are in a bullish position, you should consider:
- Lengthening the period of your moving average
- Switching to an EMA
- Shortening the period of your moving average
- Stop using moving averages and switch to a leading indicator
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