As featured in the Herald Sun – Friday 21st October 2016.
By David McCulloch – Market educator and consultant to Share Wealth Systems
The moving average is a frequently used tool in the trader’s tool box but is also one that is often underestimated. Because it is relatively simple and lacks the complexity of other technical indicators it is often overlooked, with the belief that it can’t be that good. When it comes to investing as you should know by now I am a big advocate of keeping things simple, and the moving average fits the bill nicely.
Moving averages can be applied to any timeframe and do a great job of summarising price action. There are many different variations of the moving average and the two most common ones are the simple moving average (SMA) and the exponential moving average (EMA). The simple moving average is quite basic and as the name suggests it is the sum of price over a specified look back period divided by the number of periods. Each closing price is given the same weighting. For example a 10 period moving average adds the closing prices over the last 10 periods and then divides that total by 10. As the next period closes the calculation is repeated and the averages are plotted as a line on a price chart.
An exponential moving average is calculated in a similar fashion to the simple moving average but instead of each closing price having an equal weighting (and impact) on the end result, the more recent closing prices are given a slightly higher weighting. This makes them respond more quickly to changes in price and are therefore generally favoured over the simple moving average. Successful investors typically use moving averages because they are easy to interpret and very useful in determining trends. One of the oldest sayings in the book is to trade with the trend, and the easiest way to do that is to see if the price is above the moving average.
Using several moving averages of different periods on the same chart is a useful way to highlight short, medium and longer term trends. For example when a short term trend crosses above a medium term trend it could be interpreted as a buy signal. Further trend analysis can be made by also referring to the longer term moving average to see if that is also moving in the same direction. This is a simple but effective approach, and one that will help to keep you focussed on stocks that are trending in the right direction.
For trend followers, the use of an 8, 21 and 125 period EMA is a common approach. The 8 period is used to measure the short term trend, the 21 period measures medium term trend and the 125 period measures the longer term trend. Ideally the 8 EMA will be above the 21 EMA, and the 21 EMA will be above the 125EMA. Most trading platforms have these moving averages available to plot, so next time you are thinking about a stock purchase why not bring up a chart and check out it’s trend.
David McCulloch is a market educator and consultant to Share Wealth Systems.