Moving average indicator is an important and popular indicator in technical analysis. So many traders use it as a signal to take their trading decisions or to identify the prevailing trend in the stock markets whether it is an uptrend or downtrend.
Using moving average (MA) as an indicator in your trading system ensures that you are with the majority of the stock traders and in the direction of capital flow in the stock market. This can be very helpful to you for profitable trading strategies.
You can use MA for any time period depending upon your trading or investing requirement. The most widely used moving averages for stocks are the 5 day, 10 day, 20 day, 50 day, 100 day and 200 day moving averages.
Long term investors use 200 days moving average or 50 day moving average to see the trend and bullishness in a stock. Likewise, short term traders may use 5 day, 10 day or 20 day MA for their trading purposes to play short term momentum in the stock prices.
By definition, the moving average is the mathematical average of closing prices of a stock for a particular period. We add up the closing prices for the number of periods we want to calculate the MA and divide it by the number of periods.
Closing price are preferred because they represents the trader’s psychology better than opening price or highs and lows of the stock on that trading day.
The moving averages are called as moving because everyday we include the last trading session’s closing price for calculations while leaving the first trading session closing price.
Suppose, we want 10 day MA for a stock on April 11, we take closing prices from April 1 to April 10 of that stock. If we want 10 day MA on April 12,we use values from April 2 to April 11. April 1 value gets excluded. So the average keeps on moving.
Types of Moving Averages
Depending upon the method of calculation used, moving averages are of two types – Simple and Exponential
Simple Moving Average (SMA)
The simple moving average (SMA) is the simple arithmetic mean of the values.
If we want to calculate moving average for 5 days for a stock, we need closing prices for the last 5 trading days. Then the simple moving average formula to calculate it is summing up these 5 values and divided by 5.
We don’t need to make any calculations for it. The trading software calculate it automatically for any time period you want.
Similarly, sma 20 meaning arithmetic average of the closing prices of the last 20 days for any stock.
SMA gives equal weight-age to every value while calculating the MA. That was the reason for its criticism among a section of traders. Those people believe that more weightage should be given to the more recent closing prices of stocks because they are more relevant.
50 day and 200 day make the most important SMAs. They tell the major trend in the stock market or any individual stock.
200 days moving average makes very important support level for stocks to buy for the long term. The stocks above 200 day moving average are considered to be bullish. It is always a good idea to buy stocks which are trading above 200 day sma and avoid short selling in these stocks.
Any stock below 200 dma is considered to be in bearish trend. It is always better to avoid such stocks. In fact, they are the best candidates for short selling and make money from falling stock prices.
50 day moving average acts as a medium term support for the stocks in bullish markets. Smart traders use the dip in stocks prices towards 50 dma to enter the monster stocks which are on bull run.
Before entering the stocks on the basis of 50 or 200 day SMA, it is important to ensure that the stock takes support around those levels and starts moving higher. If it does not, leave the stock,
It is not always that the stocks take support exactly at the MA level. It can always be pierced before the stock price reversal starts or the price may never reach near the moving average levels.
Exponential Moving Average (EMA)
To deal with the criticism of SMA, exponential moving average (EMA) was devised. It is the logarithmic average of the values.
Exponential moving average formula gives more weight-age to the most recent closing prices for calculation. Hence, EMA indicator gives trading signal earlier than SMA.
Traders prefer EMA in short time frames to catch the early momentum in prices. Thus, for EMA trading, short periods like 5 day, 10 day and 20 day are quite popular. SMA is more suitable for 50 day, 100 day or 200 day time periods.
To catch short term trend in security prices, you can use 10 day ema. Some traders use 20 day ema for their trading decisions. You can carry on your positions as long as the stocks respects the 10 day or 20 day ema line.
EMA trading strategy is same like sma strategy. A stock breaking and sustaining above any particular ema is expected to continue the trend and move higher. Similarly, the stock breaking and sustaining below ema is expected to continue the downtrend and move lower.
It is important that these moves are supported by the appropriate technical indicators like MACD, RSI or stochastics for any direction.
Using ema for day trading can be quite yielding. There are traders who use EMA settings for day trading at 20 periods along with RSI on a 15 minute charts.
Using Moving Average Indicator For Trading
Moving average are the technical indicators. MA in stock trading is used to find buy or sell signals for initiating a trade. Reliability of MAs depends upon the time period selected for calculating the MA.
You can use either SMA or EMA for your trading purposes. It does not make much difference. What makes difference is to stick to it with discipline.
Moving average method of trading needs back testing with the historical data. Before we use MA in our trading system, we need to see how the stock prices behaved with respect to that particular MA in the past. Find out if that MA is respected regularly or violated frequently.
Short period MA indicator generates quick signals but the probability of going these signals wrong is more.
Long period MAs take time to generate trading signals but they are likely to be more accurate.
A 5 day MA generates quick signals as compared to 20 day MA but the reliability of later is more.
When the prices move and close below a specific period MA, a sell signal is generated. When the prices move above the MA, buy signal is generated.
The major drawback of moving average indicator is that this is a lagging indicator. A lagging indicator is one which generates buy or sell signal after the up or down move in a stock or stock market has started. So, it is likely that you miss the initial move in the stock prices.
This is in contrast to leading indicators which generate buy and sell signals before the move starts in the stocks. This enables you to catch all the move which is about to happen in that stock.
Moving Average Crossover In Stock Trading
Using EMA crossing strategy than single period ema gives more confidence and reliability to a trading signal. This strategy is based on the ema crossover by two different period ema.
When a short period ema crosses above the long period ema from below, it gives a buy signal while indicating the strength in price momentum. When the short period ema crosses below the long ema from above, this gives a bearish signal.
For example, while using 5 day ema and 10 day ema crossover, 5 ema crossing above 10 ema generates buy signal. A 5 ema crossing below 10 ema generates a sell signal. Similarly, you can use 10 ema and 20 ema or 10 ema and 50 ema crossovers.
In the above image, you can see how the stock prices move in the direction of crossover. You can get big trending moves using the MAs appropriately in your trading system while keeping risks to the minimum.
You may use triple crossovers with 4 day, 9 day and 18 day period MAs to get more precise and reliable buy and sell signals.
A buy signal is generated when 4 day MA crosses above 9 day MA. The buy signal is confirmed when 9 day MA also crosses above 18 day MA.
A sell signal is generated when these MAs cross lower.
The stock prices close below the long term MA can be kept as your stop loss while prices sustaining above short term MAs is an indication of momentum in the stock prices.
To protect the profits, you can also prefer to book your profits when the stock closes below the short term MA instead of waiting for close below the long term MA.