Successful investing with Moving Averages.

Moving average is a term coming from statistics. It is used to analyze time series - a sequence of data points measured usually at successive time intervals. Closing stocks prices are exactly such time series, so we can use moving averages to analyze them.

We distinct two most important types of moving averages based on how they are calculated.

Simple Moving Average

A Simple Moving Average is a simple mean from all data points we take into calculation. It means that old data influence it in same way like the latest data.

Exponential Moving Average

An Exponential Moving Average exponentially decreases the weight of past data.

We also distinct different moving averages, depending on number of data points we use in analysis. Among most popular are 5, 15, 30, 45, 50, 100 and even 200-days moving averages.

The role of moving averages is to reduce “noise”, smooth out price changes. This helps us to determine trend direction.

How to use them?

A lot of traders wait for averages to cross each other. When average of shorter term crosses the longer term one, it is signal to buy stocks. The signal is stronger when averages are rising. It means that we have an uptrend. Depending on average type, longer average is rising – longer term of trend. Usually I buy stocks when both conditions are fulfilled: averages are crossing and averages are rising.

Take a look at the following examples (I use EMA 15, EMA 30 and EMA 45):

Apple

This is chart of last year - Apple. We buy stocks around point (1). Probably even a little earlier. All three averages are going upward. Around (2) EMA 15 and EMA 30 starts to go down. EMA 15 crosses down EMA 30, EMA 30 crosses down EMA 45. It is signal for us to sell. But we have already got a nice return of investment. Soon, (3) moving averages again take direction to the north, so it is time to buy stocks again. This time we earn more, as we keep till (4) where averages cross and head down. As you can see, it indicated further strong downward movement

Google.

Another chart is last year Google. Similar situation. We open long position around (1). This transaction seems to be not so profitable, as we relatively early get signal to close (2). Return of investment is not so impressive, but it is still ok. You must remember that moving averages don’t guarantee 100% successful investments. But they are working really well in most cases and are very easy to use. Ok, let’s continue. Soon (3), we see as all averages again headed north, EMA 15 on top, below is EMA 30, EMA 45 on bottom. Great, we buy. Till (4) there was no real reason to sell. Maybe we could try to avoid strong downward movement which was in the middle of November, but usually I don’t try to predict and exploit such changes. What is next? Stock prices rebound from this down but Google doesn’t have enough strength to beat last maximum. Soon, we can see how it influences moving averages, as they start to move horizontal and finally downward. (4) looks like a good time to sell it.

Of course we can use moving averages to analyze indexes. Below is last 2 years of S&P500.

S&P500

We start from (1). Moving averages go up, EMA15 (red) > EMA30 (purple) > EMA45 (cyan), so it is an indication of strong uptrend. This uptrend occurs quite long, but finally around (2) we see strong movement in south direction. Fortunately it was short down, S&P500 quickly returns to upward movement. (3) is another point when we get signals to leave this index. S&P500 tries to return to the uptrend (4), but soon it seems that it has not enough strength (5) and we should stay away from it. You can see what happened further.

As you can see, using moving averages is very easy and effective. It is one of my favorite tools from technical analysis. Please, keep in mind that this technique can also give wrong signals. Of course it happens rarely and we are able to react quite quickly when it happens. There are also other techniques of investing using moving averages. Stay tuned, I will post about them soon.