How to Use Moving Averages for Stock Trading

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On-screen text: Disclosure - Stock trading involves risks, and you can experience a significant loss of funds invested.

Narrator: Technical analysts often say the trend is your friend because they think a security that’s going up is more likely to keep going up and a security that’s going down is more likely to keep going down. Having a clear view of the trend can help an investor decide whether to buy, sell, or hold a position.

However, sometimes determining the trend can be difficult and that’s why this video is so important.
 
A simple moving average is a technical indicator, or tool, that tracks a security’s price over a time period and plots it on a line.
 
This essentially “smooths out” price fluctuations to give an investor a general idea where the trend is heading.
 
Using simple moving averages to determine trends, an investor can better identify buy and sell signals.
 
To create a simple moving average chart, start by choosing a time frame. A time frame can be any period of time, including a day, a week, or even a month.
 
For this example, we’ll define a period as a day. Let’s create a moving average using a 20-day chart. 
 
We’ll take each day’s price and add them together. 

Then we’ll divide that number by our time frame number, which in this case is 20.
 
This gives us today’s 20-day average price, which is a short-term moving time frame—and one that active traders may use.
 
To create a moving average, each day we’ll drop the last day in the time frame and add today’s.
 
A 20-day moving average can help determine short-term uptrends, downtrends, and sideways trends.
 
Examining a security’s moving average in relation to its current price can help investors identify potential buy signals.
 
For example, when a price breaks above an upwardly sloping moving average, this could mean it’s a good time to buy a stock.

Another buy signal could be a “support bounce”. This is when the security’s moving average acts as a support level for the price. When the price comes down to the moving average and then rallies up again, this “bounce” could be used as a buy signal.
 
On the flip side, moving averages can also help investors know when to sell a position.
 
For example, if the stock’s price rises to the moving average and bounces, this might be a sell signal.
 
Looking at a simple moving average over a short-term time frame can be very helpful, but it has its drawbacks.
 
One thing to be aware of is “whipsaws”. A whipsaw is when the stock crosses over the moving average, giving one signal, and then reverses quickly, giving the opposite signal.
 
A short-term time frame, like 20 days, usually shows more whipsaws, which is why some investors may prefer to use intermediate- and long-term time frames.
 
For example, intermediate-term charts with a 50-day moving average show a smoother average and have fewer buy and sell signals. As a result, the investor may stay in the trade longer.
 
Long-term trends, like those found with a 200-day moving average, are even smoother.
 
When looking at all these averages together, we can see that the short-term average is confirmed by the intermediate- and long-term averages.
 
The main disadvantage of any simple moving average is that they’re slow to reflect price changes. Because each period is given equal weight, day 50 counts as much as day one.
 
As you can see, a large gain or drop hardly factors into a moving average for some time. This is known as lag.
 
Let’s look at an example to illustrate this. If you use a simple moving average for buy and sell signals, your stock could experience a huge pullback well before the simple average reflects this activity.
 
To avoid lag, consider using another analysis, such as a weighted moving average or exponential moving average.

These types of moving averages consider recent data the most relevant and give it more “weight”. Consequently, these types of moving average lines react quickly to the security’s price changes. This is helpful for active traders who want to place short-term trades.

It’s also important to note that moving averages don’t predict future performance—they only confirm established trends. Even with these drawbacks, moving averages are a powerful tool of technical analysis that can help you determine trends and identify buy and sell signals.

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