Moving Averages

● What Are Moving Averages?

Simply put, a moving average (MA) is the average of a stock price over a set period of time. For example, a 10 day moving average is the average of the last 10 day’s prices. Moving averages can be set to any period of time. If you are looking at a weekly chart instead of a daily chart, the moving average will average each week’s price as opposed to each day’s.

Below is a daily chart of Cisco Systems (CSCO) with a 20 day moving plotted over it.

Fig 3.1 Click to Enlarge.

The 20 day moving average creates a smoothing effect. It allows one to see the general trend without getting distracted by choppiness or extreme moves. Sometimes moving averages are used to replace trend lines.

● How to Use a Single Moving Average

Spotting the Trend

One use of a single moving average to trade stocks is to spot the trend. The longer you make the moving average, the longer the trend it will tell of. For example, a 5 day MA may be relevant to someone wanting to trade stocks in terms of a few days, but a 200 day MA might be relevant to someone wanting to invest for years.

Fig 3.2 Click to Enlarge.

Each point on the 50 week MA is the average of the past 50 weeks of price data. Just taking a quick glance reveals that the Dow Jones, around 2000, switched from an uptrend to a downtrend. This chart, because it’s a weekly chart dealing with a fairly long-term moving average, would be relevant to someone investing in terms of years. (What exactly constitutes a “long” moving average is somewhat arbitrary and is ultimately to product of your own judgment and experience.)

           
● Above or Below the Moving Average?

Another use of a single moving average is to see if the price is above or below it. If the price is trading above its moving average, it’s considered a bullish sign. If a stock is trading below its moving average, it’s considered a bearish sign. Again, what the length of the moving average is depends on your timeframe for trading.

Fig 3.3 Click to Enlarge.

Notice that during that move up, the NASDAQ stayed above its 50 week MA for almost the entire time. Many stocks that experience strong moves up stay above their moving averages for extended periods of time. Any break below it can signal trouble.

● How to Trade Stocks Use Multiple Moving Averages

The Crossover

A common way of using multiple moving averages is the crossover. In its simplest form, the crossover consists of two moving averages, one being shorter than the other. When the shorter one crosses below the longer one, it’s a bearish sign. When the shorter one crosses above the longer one, it’s a bullish sign.

Fig 3.4 Click to Enlarge.

As you can see in the chart, from ’97 all the way until mid ’00, the NASDAQ’s 20 week moving average (red) stayed above its 50 week moving average (blue). When the 20 day MA crossed below the 50 day MA, a bearish crossover occurred, and the NASDAQ subsequently broke down.

● Popular Uses of Moving Averages

• Wondering what length to make your moving averages? A place to start is with the three most popular: 20, 50, and 200. Why are these so popular? In all seriousness, it’s probably because they’re nice round numbers. There’s really nothing special about them. However, it’s a fact that most technicians follow these three lengths, so there tends to be a self-fulfilling prophecy effect because everyone is watching them. At any rate, keep them in mind.
  
  
• The 50 and 200 day MA crossover is very widely followed. Anytime the 50 day MA crosses above or below the 200 day MA, you can bet many people are taking notice.
   
• Also widely followed is whether or not a stock is trading above or below its 200 day MA.