For those looking to incorporate Technical Analysis (TA) into their trading methods, the use of moving averages (MA) is certainly one of the first things that should be covered. MA’s are great because they can be used in a variety of ways—several of which I will touch on in this blog post. Simply put, a MA is a tool used to show a “smoothing of data” for whichever time period is represented on the chart—this could be intraday (minutes, half hours, hours), daily, weekly, monthly, quarterly, or even yearly timeframes. Technicians use these tools on their charts, and I find them extremely useful in trying to makes sense of all the “noise” that can come with looking at a set of data.
There several methods of calculating moving averages (I’ll mention just two) and will mostly focus on the simple moving average (SMA). The SMA is calculated by adding the prior periods of a set of data and dividing by the number of periods the line represents—i.e. the chart below for Apple (AAPL) shows the 20 day SMA (blue line), which was calculated by adding up the closing prices for the prior 20 days of trading and then dividing by 20. At any point on this line, you can calculate the moving average, and, based on yesterday’s close (3/18), AAPL’s 20 day SMA was $438.98—easy enough, right?
The next chart looks at the 20-day exponential moving average (EMA) for AAPL. The EMA is calculated in a slightly different way. I won’t get into the specifics of the math (review the embedded link in the first paragraph), but what is important to know is that the EMA weighs the data differently and that this depends on the length of the MA. If you look very closely at the 20 day EMA for AAPL, you can see some differences in the trendline (20 day EMA is $442.04).
A few of the basics have been covered, and now I really want to emphasize the importance of MA’s, and how they are very useful in TA. Nearly everyone will point towards the 50 day SMA and the 200 day SMA as “reference points”. It is a “rule of thumb” that if a stock is trending above its 50 day MA, it is in a short-term uptrend, and, if it is trending above its 200 day MA, then it is in a long-term uptrend. With the AAPL chart below, you can clearly see that it is trending well below both since it hit its peak in September, 2012. In your analysis, I would remember this: it is not the moving average itself that always matters, but rather the slope of the reference point that is the most important detail. This will help you to correctly assess the trend.
The crossing of moving averages is often used as a” trading signal” by many. Two of the more well-known crosses are the “death cross” and the “golden cross”. Basically, it is considered a “buy signal” when the 50 day SMA crosses above the 200 day SMA, and a “sell signal” when the 50 day SMA crosses below the 200 day. The death cross in AAPL that is illustrated above, did indeed show a good point at which to sell, but it by no means marked the best spot to sell—in fact, it was several months late. Personally, I don’t put a lot of stock into these types of crosses as too many traders tend to look at them. Again, I am more interested in the slope of the moving averages and using this (along with several other indicators and overlays) in my assessment of whether or not to buy or sell.
Just like price levels can act as support/resistance, moving averages appear to provide significant points of support and/or resistance. Take the daily chart of Abercrombie & Fitch (ANF) below as an example. This has been a stock that I have been eyeing. ANF has been trading on what appears to be support at its 80 day SMA (a moving average that I like to use on my charts). Looking back at its previous price action and determining if the 80 day SMA has been supportive in the past (or acted as resistance) is always a must—and the more price points that you can see either “bouncing” from this trendline or being rejected, then the more critical this time period may prove to be.
To be sure, I’ve just scratched the surface and given some simple examples of MA’s and how they can be useful in trading. MA’s are used in other types of technical indicators/overlays, one of which I’ve touched on before. Remember that MA’s can be used for some very simple things: a smoothing of data, determining the overall trend, and finding possible points of support/resistance. These three things will serve you will in your trading, and can be used to analyze equities in an infinite number of ways.