Using Moving Average to Determine Trend and Entries
For many years I traded stocks based exclusively on the technical analysis of price charts. As I claimed in my first book, Trend Trading for a Living, it didn’t matter to me whether the company made widgets or shmidgets, I bought and sold shares based on the chart and the chart alone. In fact, in many cases I knew nothing about the company other than its ticker symbol.
I’ve since educated myself in the finer points of fundamental analysis, and for good reason. Familiarity with a company’s growth and valuation metrics can go a long way toward selecting out the best price charts from all the rest. More importantly, strong fundamentals more often than not trump short-term technical weakness, keeping you in the trade long enough to reap the rewards of the stock’ eventual turnaround. As Warran Buffett is fond of saying, “It’s not the buying and selling that makes money. It’s the waiting!”
Still, technical analysis should play a part in any robust trading system. And one of the most widely used of the technical indicators, one you’ll find on almost every price chart, is the moving average. A moving average, as the name implies, is a running average of the closing price of a stock over x number of time periods (normally x number of days or weeks), with each new closing price replacing the first price in the sequence. The most commonly used moving averages are the 50-day moving average, which shows the average stock price over the past 10 weeks, and the 200-day moving average, which does the same for the past 40 weeks. Shorter term moving averages are used to determine the state of the short-term trend. Longer term averages are used to determine the long-term trend. These two averages, the 50-day and 200-day, are so widely used that even the staunchest company analyst, who otherwise would never think to consult a stock price chart, will always know where the stock price stands in relation to one or both of these two key indicators.
There are a number of key benefits to using moving averages on a price chart. We won’t be able to go over all them in this article. Here let me explain that the most important use of moving averages is that they smooth out the “noise” of the day to day ups and downs of price movement. Moving averages render more clearly the upward, downward, or flat directional flow of a stock’s price over time. Even the choppiest of price charts, with a 50-day or 200-day moving average overlaid, will show clearly defined movement. In this way, a quick glance at the moving average of price is all you need to tell whether the stock’s share price is in an uptrend or downtrend, or whether it has, despite the noise, flat-lined.
The S&P 500 with the 50-day Moving Average
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