A commonly used market indicator for both stock trading and investing is the moving average. Investors who keep an eye on the important moving averages will be able to buy and sell at the most advantageous times. The value of using moving averages is that they help you see trends and average out the sort of brief market fluctuations that commonly confuse the issue. These averages are calculated over a variety of time periods and using several different methods. Matching the average that you use to your type of investing or trading is important.
Why Moving Averages Are Important
When you trade or invest in stocks, you need tools that help you stay in touch with price action. Even if you are investing in stocks for the long term, you would rather purchase at a low price instead of a high one. Why moving averages are important is because they smooth out the “static” of short term price movement.
Different Moving Averages
The most commonly employed are the fifty, one hundred, and two hundred day time periods for this approach. In general, the longer the time period the less the indicator will be affected by short term ups and downs. For many traders, the two day average is a benchmark for buying versus selling. Many only buy when prices are above that average and quickly sell when they are below.
The shorter time periods of five, ten, twenty, or even fifty days are useful in recognizing short term trends for swing trading. If your focus in on day trading, a ten day average that updates every hour is good.
Most Used Moving Averages
Which one of these time frames you employ will always depend on your investment and trading time horizons. Short time frames go with short term trading and longer periods go with timing long term investments. In addition, there are simple moving averages and more complex ones within each time frame. Your choice will often depend on whether you are using it as an indicator of the trend line or employing it as a baseline on top of which you use more sophisticated technical indicators.
A simple moving average is based on average prices while an exponential moving average gives more weight to recent price changes. You can set up yours based on opening or closing price, low price, high price, or a combination. Each approach has its advantages.
Moving Average Volatility
Traders use this tool to accurately predict market trends and reversals. While a simple average is easier to understand, it may be too slow in spotting price changes. The exponential average is often more accurate in predicting near-term changes. The same can be true of the double exponential moving average, aka DEMA. Volatility is smoothed out with longer time-frames but with a loss of short-term precision.
Moving Average Secrets
A way that many traders and investors get around the lack of precision with longer time-frames is to use the DEMA using this formula:
DEMA = 2*EMA — EMA(EMA)
When you use this approach with a hundred day or two hundred day average, you get the longer term average that smooths out daily price fluctuations as well as the more sensitive indicator for market changes. In addition, savvy traders often use both a shorter term average as well as a longer term one for a broader view of the market.
Moving Average Stock Strategy
While this approach is very valuable, it has its flaws as well. It is a backward-looking indicator that only sees the time-frame for which it is calculated. Thus it does not “know” about market cycles or fundamental analysis indicators such as new products or competitors in a market sector. The best moving average stock strategy is to combine this analysis tool with other methods.
Mastering Moving Averages
As with all trading and investing tools, practice makes perfect. We often advise being stock traders to use simulation trading until they get the hang of the various indicators and tools available. The same applies to mastering moving averages. Add the most important moving averages for more successful trades and investments!