Trading Stocks Using Moving Averages
Using Moving Averages When Trading Stocks
In the world of stocks and investing, one has many different tools at their disposal to try and make trading decisions.
Some tools are quite simple while others can become quite complicated.
Some of the types of tools available include oscillators, volume studies, momentum indicators and trend identification tools such as moving averages.
Here we will outline the use of moving averages as they are one of the most popular indicators used.
What Exactly Are Moving Averages?
Moving averages are a mathematical indicator that smooth price data.
Moving averages are most commonly used to try and identify a trend within a market.
There are different types of moving averages that one can use such as simple or exponential.
Moving averages are the backbone of many other technical studies widely used today such as the MACD and Bollinger Bands.
It is important to note that moving averages are a lagging indicator and do not predict future market prices.
These indicators are used primarily to filter out a lot of the market "noise" to see if a trend exists.
How Are Moving Averages Set Up?
Moving averages can be used with many different settings.
One can use different time frames for smoothing data depending on what one's trading goals and time frame are.
Here we will look at some of the more popular settings for moving averages, and examine the 9 and 18 day moving average settings.
In addition, we will look at two different types of moving averages: Simple and exponential.
A simple moving average is the average price of a security over a specified time period.
Therefore, a 9 period moving average is the average price of that security over the last 9 trading days or periods.
Please note that closing prices are most often used for moving average calculations.
So, the 9 day simple moving average is simply the average of the last 9 trading days.
One should also note that any time frame may be used.
For example, if one is looking at a five minute chart of a stock, then the 9 period moving average will use the closing price values for the last 9 five minute bars or candles.
The 18 day or period simple moving average is calculated the same way except that the average of closing prices over 18 periods is taken rather than 9.
One can use any time frame that they like for this indicator such as 9,18,21,40,50 or 200.
Exponential moving averages are moving averages that reduce the lag effect by placing more weight on recent prices.
Calculating an exponential moving average is more complicated than a simple moving average.
The exponential moving average does begin with a simple moving average, however, it then applies a weighting multiplier.
One type of moving average is not necessarily better than the other.
An exponential moving average has less lag and will turn faster than a simple moving average while a simple moving average will give one a true average of prices over the specified time period.
The type of moving average used may depend on the trader's preference, market traded, time frame and other factors.
What Are Some Ways To Use Moving Averages?
Moving averages are primarily used to identify a trend within a market.
There are many different ways these indicators may be used.
Here we will outline two of the more common ways traders use these indicators:
Moving Average Crossovers -
Moving averages may sometimes be used to trigger trades based on crossovers.
For example, if one is using a 9 and an 18 day moving average, then one may take a buy signal when the 9 day average crosses over the 18.
Conversely, one may take a sell signal when the 9 day crosses below the 18.
The shorter-term moving average is used as the signal average.
When the short-term average crosses above or below a longer-term moving average, it may indicate that prices are trending in that direction and that momentum may be building.
One can use these crossovers for exit signals as well as entry signals.
Buying Pullbacks or Selling Rallies -
Another simple way to use a moving average is to enter a market in the direction of the trend on a pullback.
For example, one popular method is to buy a pullback to the 20 day moving average if the average is pointing up.
Conversely, one could sell a rally to the 20 day average if the average is pointing down.
These are some of the simpler ways these moving averages may be used.
There are numerous ways these moving averages may be used, and traders must get comfortable with whatever method they choose.
Option trades may be utilized as well as purchases or sales of the underlying.
For example, if one is looking to get long on a pullback to the 20 day moving average, then he or she may simply buy calls or call spreads or sell puts or put spreads rather than buying shares.
As with any other type of indicator or technical tool, moving averages are not a "Holy Grail."
These averages can be very useful in identifying a trend within a market and may also be useful for generating trade signals.
That being said, the more information one has when making a trading decision the better.
When one combines moving averages with other indicators or past support or resistance levels, the moving averages may potentially be even more powerful.