Learn How to Use Moving Average Effectively to Make Your Trade Decision
Definition Moving average is a lagging technical indicator that is used to identify a trend in the price of a financial instrument.
It is useful because it filters out the noise in price and highlights the trend.
Mathematically, it is an average of daily closing prices for a specified number of days.
It is called 'moving' because the averaging window is moved as we move forward in time.
It can be very effective tool in the trending market but not as effective when the prices swing up and down.
Types There are many types, but the two most common are: 1.
Simple Moving Average (S.
M.
A.
) - This is calculated by giving the same weight to all data points.
This is the average that we all learned in high-school or college.
2.
Exponential Moving Average (E.
M.
A.
) - This is calculated by giving more weight to the more recent data point.
This is done because recent data is more relevant than older data.
It reacts faster to the price changes than S.
M.
A.
Time Frame Another important property is the time frame over which the average is calculated.
A 20-day S.
M.
A.
is an average of closing prices for the past 20 days; 50-day S.
M.
A.
is the average for 50 days and so on.
The shorter the time, the faster it reacts to the changes in the price.
How to trade? There are three major strategies that are used to trade based on moving averages.
All strategies attempt to identify the start and end of a trend.
To profit from a trend, you must buy the stock at the start of an increasing trend and sell it when the trend ceases to exist.
1.
Follow Moving Average: In this strategy, you buy when the moving average starts increasing and sell when it starts decreasing.
This is the most simple strategy but nevertheless very effective.
This works because when the moving average is increasing, that means the price is increasing indicating an up trend.
2.
Price crossover: In this strategy, you buy when the price is greater than the moving average and sell when the price is less than the moving average.
When the price crosses over, it indicates the start of an up trend.
3.
Slow and Fast crossover: In this strategy, you use two moving averages for two different time frames (for example: 20-day S.
M.
A.
and 50-day S.
M.
A.
).
Buy when the faster one crosses over the slower one and sell when faster one crosses under the slower one.
Will these strategies work? The strategies have proven to work at varying degree depending on what parameters you pick.
Every trader who trades based on technical analysis is likely to have it on his or her chart.
What affect the strategy's performance are the variables that go with the strategy - its type (S.
M.
A.
or E.
M.
A.
), time frame, and the stock you exercise the strategy on.
There are no magical numbers that will make your strategy work on all stocks at all times.
You will have to come up with your own combination by experimenting with different stocks.
This is where virtual trading site like Strategyard.
com come in handy.
You can create different strategies with different combinations and evaluate them.
Once you have a strategy that you are comfortable with, you can start trading in real market and make some money.
It is useful because it filters out the noise in price and highlights the trend.
Mathematically, it is an average of daily closing prices for a specified number of days.
It is called 'moving' because the averaging window is moved as we move forward in time.
It can be very effective tool in the trending market but not as effective when the prices swing up and down.
Types There are many types, but the two most common are: 1.
Simple Moving Average (S.
M.
A.
) - This is calculated by giving the same weight to all data points.
This is the average that we all learned in high-school or college.
2.
Exponential Moving Average (E.
M.
A.
) - This is calculated by giving more weight to the more recent data point.
This is done because recent data is more relevant than older data.
It reacts faster to the price changes than S.
M.
A.
Time Frame Another important property is the time frame over which the average is calculated.
A 20-day S.
M.
A.
is an average of closing prices for the past 20 days; 50-day S.
M.
A.
is the average for 50 days and so on.
The shorter the time, the faster it reacts to the changes in the price.
How to trade? There are three major strategies that are used to trade based on moving averages.
All strategies attempt to identify the start and end of a trend.
To profit from a trend, you must buy the stock at the start of an increasing trend and sell it when the trend ceases to exist.
1.
Follow Moving Average: In this strategy, you buy when the moving average starts increasing and sell when it starts decreasing.
This is the most simple strategy but nevertheless very effective.
This works because when the moving average is increasing, that means the price is increasing indicating an up trend.
2.
Price crossover: In this strategy, you buy when the price is greater than the moving average and sell when the price is less than the moving average.
When the price crosses over, it indicates the start of an up trend.
3.
Slow and Fast crossover: In this strategy, you use two moving averages for two different time frames (for example: 20-day S.
M.
A.
and 50-day S.
M.
A.
).
Buy when the faster one crosses over the slower one and sell when faster one crosses under the slower one.
Will these strategies work? The strategies have proven to work at varying degree depending on what parameters you pick.
Every trader who trades based on technical analysis is likely to have it on his or her chart.
What affect the strategy's performance are the variables that go with the strategy - its type (S.
M.
A.
or E.
M.
A.
), time frame, and the stock you exercise the strategy on.
There are no magical numbers that will make your strategy work on all stocks at all times.
You will have to come up with your own combination by experimenting with different stocks.
This is where virtual trading site like Strategyard.
com come in handy.
You can create different strategies with different combinations and evaluate them.
Once you have a strategy that you are comfortable with, you can start trading in real market and make some money.
