Trading by Using Simple Moving Averages
Technical analysts frequently say that the trend is your friend because they believe that a security that is rising is more likely to continue rising, and a security that is falling is more likely to continue falling. A clear view of the trend can help an investor decide whether to buy, sell, or hold a position, but determining the trend can be difficult at times.
A simple moving average is a technical indicator or tool that tracks the price of a security over time and plots it on a line, smoothing out price fluctuations to give an investor an idea of where the trend is heading. An investor can better identify buy and sell signals by using simple moving averages to determine trends. To begin creating a simple moving average chart, select a time frame. A time frame can be any period of time, such as a day, a week, or even a month. For example, we will define a period as a day and use a 5-day chart to create a moving average. We will add each day’s price and divide that total by our time frame number, which in this case is 5.
Daily Closing Prices: 110,120,130,140,150,160,170
First day of 5-day SMA: (110 + 120 + 130 + 140 + 150) / 5 = 130
Second day of 5-day SMA: (120 + 130 + 140 + 150 + 160) / 5 = 140 {drop 110 and add 160}
Third day of 5-day SMA: (130 + 140 + 150 + 160 + 170) / 5 = 150 {drop 120 and add 170}
This gives us the 5-day average price for today, which is a short-term moving time frame that active traders may use. To calculate a moving average for each day, he or she will subtract the beginning day from the time frame and add the next to the ending day (so that n = 5). Similarly, we can create any time frame (let us say 5 days, 20 days, or 100-days). A 20-day moving average can help determine short-term uptrends, downtrends, and sideways trends when examining a security’s moving average to its current price. This can assist investors in identifying potential buy signals, such as when price breaks above an upwardly sloping moving average, which could indicate that it is a good time to buy a stock.
Another possible buy signal is a support bounce, which occurs when the security’s moving average acts as a support level for the price. If the price falls to the moving average and then rises again, this bounce could be used as a buy signal.
Moving averages, on the other hand, can assist investors in determining when to exit a position. For example, if the stock price rises to the moving average and then bounces, it could be a sell signal.
Looking at a simple moving average over a short time the frame can be very useful, but it has some drawbacks, one of which is whipsaws (a whipsaw is when the stock crosses over the moving average giving one signal and then reverses quickly giving the opposite signal).
Short-term time frames, such as 20 days, typically exhibit more whipsaws, so some investors may prefer to use intermediate and long-term time frames. Intermediate-term charts with a 50-day moving average, for example, have a smoother average and fewer buy and sell signals. As a result, the investor may stay in the trade for a longer period of time. Long-term trends, such as those found with a 200-day moving average, are even smoother when all of these averages are considered together. We can see that the intermediate and long-term averages confirm the short-term average.
The main disadvantage of using a simple moving average is that it takes a long time to reflect price changes. Because each period is given equal weight, day 50 counts the same as day one, and a large gain or drop hardly ever factors into a moving average for some time. To avoid lag, use a simple moving average for buy and sell signals. If you use a simple moving average for buy and sell signals, your stock may experience a large pullback well before the simple average reflects this activity.
Consider using a different analysis, such as a weighted or exponential moving average. These types of moving averages consider the most recent data to be the most relevant and give it more weight; as a result, these types of moving average lines react quickly to changes in the price of securities. This is advantageous for active traders looking to place short-term trades. It is also worth noting that moving averages do not predict future performance; rather, they only confirm existing trends. Despite these disadvantages, moving averages are a powerful technical analysis tool that can assist you in determining trends and identifying buy and sell signals.