If you check out the chart of stocks, you may have noticed random price fluctuations. The price action of the stock may appear choppy, giving no clear indication of the trend. In order to get a clear price action and stock direction, one of the popular indicator used in the technical analysis is the Moving Averages (MA).
What are Moving Averages?
Moving Averages are trend following lagging indicator. They basically help in ‘filtering out’ the noises from the price fluctuations, giving a clearer picture of the stock’s direction.
There are two types of commonly used Moving Averages – Simple Moving Average (SMA) and the Exponential Moving Average (EMA).
- An SMA is formed by the simple average of closing prices of a stock over a specific number of days
- An EMA is formed by giving a higher weightage to the recent close prices of the stock.
The Uses of Moving Averages
Moving averages are mainly used for identifying the trend direction of the stock and for identifying the support and resistance levels of the stock. They also form the basis of indicators like Moving Average Convergence Divergence (MACD) and percentage price oscillator (PPO).
- Whenever the moving averages are rising, they indicate a possible uptrend.
- A declining moving average is indicative of a possible downtrend.
- Whenever a shorter term MA crosses above the longer-term MA, it shows an upward momentum. A possible bullish signal is generated in this case.
- When a shorter term MA crosses below the longer term MA, it shows a downward momentum. A possible bearish signal is generated in this case.
- Whenever the price of a stock crosses above the MA, a bullish signal is generated.
- Whenever the price of a stock crosses below the MA, a bearish signal is generated.
- MA lines generally act as the support level of the stock whenever there is a correction during an uptrend.
- MA lines generally act as a resistance level in case the stock bounces upwards during a downtrend.
How to Use MAs for Making Better Trades
Moving Averages can be used for picking out some strategic trades. Here’s how experienced traders use moving averages.
Long and Short Positions
#1 MA Crosses: Whenever short-term MA crosses over its long-term MA, traders go long. Similarly, whenever shor- term MA crosses below its long-term MA, traders go short.
The figure below shows that the ideal level to enter a long position is when the shorter MA crosses above longer MA.
#2 Price Crossover: Traders enter long positions whenever the price crosses above the short-term MA. Traders enter short positions whenever the price crosses below the short-term MA.
#3 MA as Dynamic Support and Resistance: Traders enter long positions whenever the stock takes support at its short-term MA. However, take note that this is done only when the stock is on a clear uptrend, with prices trading above both short-term as well as long-term MA. By trading this way, traders take advantage of the corrections during an uptrend.
Similarly, traders take short positions whenever the stock bounces up during a downtrend and encounters resistance from the short-term MA. However, take note that this is done only when the stock is in a clear downtrend, with prices trading below both short-term as well as long-term MA.
The figure below shows how a short-term MA acts as a support level for the stock.