As more and more stock traders enter the markets, technical analysis is becoming the research tool of choice. Traders, people who try to capitalise on the short term movements of a stock, prefer to use chart or technical analysis more heavily than fundamental analysis because sometimes good companies have bad stocks for short periods of time. Just because the company looks good on paper doesn’t mean that the stock price will reflect that‚ at least not in the short term. For this reason, fundamental analysis isn’t as helpful for short term traders. Instead, they look at the charts.
Charts are full of technical information but to be realistic, much of it isn’t relevant or even useful to the bulk of traders. Technical analysts can find collections of patterns in any stock chart but without knowing the probabilities of success associated with those patterns, it’s hard to capitalise on finding such patterns as a cup and handle. (Never heard of a cup and handle pattern? Don’t worry)
Somewhere near the top of the list of most important chart information would be the moving average. Anybody who reads a chart looks very closely at the moving averages and you should too. Let’s figure out what these moving averages are and how they can help us.
What is It?
You probably learned about averages in grade school. Add up the total of the numbers and divide by the amount of data points. If you have a 5,6,7,8,9, you would find the av-erage of those numbers by totalling the numbers and dividing by 5. A moving average (in statistics, a moving average, is also called rolling average, rolling mean or running average) works the same way. If you wanted a 30 day moving average you would total the closing stock price for the last 30 days and divide by 30. On the next day you would recalculate that by adding the newest closing price and deleting the oldest.
Of course computers do all of the work for us. We don’t have to get out our pencil and paper any more because the computer calculates the average for us and plots it on the chart.
Exponential Moving Average
We learned about the simple moving average but there is another called the exponential moving average. As the world reacts faster to news, the value of older data becomes less important to technical analysts. The exponential moving average puts more weight on the newest data and less weight on the older data. Med andre ord, not all data is treated equally with the exponential moving average. We won’t get in to the calculations for it. We’ll trust that our computer is calculating it correctly for us.
Now that you know what a moving average is and how it works, another question arises: How many days should I look at? You could look at a 10 day moving average, en 300 day or anything in between but unless you know what other investors are looking at, the moving average is of little use to you.
It would be nice if there were a hard and fast answer to this but unfortunately, there isn’t. There are, however, some time frames that most people feel are important. First, the 200 day moving average is considered important as a measure of longer term strength or weakness. If a stock goes below its 200 day moving average, that might be an indication of longer term weakness by some.
One of the most important is the 50 day moving average. If you watch financial televi-sion, you’ll hear the 50 day used as a very powerful indicator. If a stock moves and stays above its 50 day moving average, that’s a sign of strength.
Finally, the 20 day moving average is a short term indicator. Investors sometimes view the 20 day in relation to the 50 day. If a stock moves above or below the 20 day moving average, it may be on its way to testing the 50 day.
How to Use it
These moving averages often act as support and resistance levels. If you look at stock charts you’ll notice that moving stocks may drop to a certain moving average and then head back higher. In this case the moving average acted as a support level. In other cases, the stock may rise and have a tough time moving above a moving average. In this case, it acts as resistance. Traders use this behaviour as a way to forecast where the stock will go in the future. Some computerised trading firms set buy and sell levels based on moving averages.
If you see a stock that is sitting at a support level, buying it might be a good idea. If it is having trouble getting through the resistance, it might be destined for a correction to the downside.
None of these rules are absolute. All investors have their unique ways of using the moving averages. As you learn more, you will develop your own rules as well.
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David is a writer who reviews credit cards on CreditCardCompare.com.au, a comparison website based in Aus-tralia. He has an interest in investments, which is a topic he has previously written about on their blog.