One thing I know for sure in the plethora of technical indicators is this. They can be confusing and overwhelming if you don't know what you're doing.
If you're looking for an easy to understand and handy technical indicator, look no further. Here's how to use moving averages to trade trends.
Many traders like to use moving averages to trade trends because it usually does not require a speedy decision-making process and trade execution. More often than not, it doesn't require the use of hotkeys.
Hotkeys are great for traders who want to get in an out of a trade at lightening speed. However, if you know how to use moving averages to trade trends then you've had great stock training.
As their name implies, a moving average is an average that moves. Because of this, old price data's dropped as new data becomes available; causing the average to move along the time scale.
As a result, moving averages smooth price data to form a trend following indicator. What's important to note is they lag behind as they're based on past prices.
Nevertheless, please recognize they don't predict price direction, but rather define the current price direction. So do you know how to use moving averages to trade trends?
In my opinion, what sets moving averages apart from other indicators is their ability to smooth price action and filter out the noise. Better yet, they form the building blocks for many of the other technical indicators out there; i.e Bollinger Bands, MACD and the McClellan Oscillator.
Two of the most popular types of moving averages are the Simple Moving Average (SMA) and the Exponential Moving Average (EMA).
Like I mentioned above, they can be used to identify the direction of the trend or define potential support and resistance levels. This is great for stock market trading.
When you know how to use moving averages to trade trends, then you can use the SMA. We calculate the average price of a stock over a specific number of periods to obtain the simple moving average.
More specifically, we add up the closing price of a stock over a number of time periods then dividing that figure by the actual number of time periods.
For example, a 5-day simple moving average is the five-day sum of a stocks closing price divided by five.
The formula to calculate is as follows:
Simple moving average = (P1 + P2 + P3 + P4 + ... + Pn) / n
In fact, we use moving averages as part of the tools used to build our stock watch lists.
Exponential moving averages differ from simple moving averages. A given day's EMA calculation depends on the EMA calculations for all the days prior to that day.
Because of this, EMAs reflects the latest chages in the price of stock more than the other moving averages do. Given the fact that EMAs give more weight to the most recent prices, they end up reducing the lag.
For example, you need far more than 10 days of data to calculate a reasonably accurate 10-day EMA.
The formula for calculating is as follows:
Exponential moving average = [Close - previous EMA] * (2 / n+1) + previous EMA
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Even though there are clear differences between SMAs and EMA, one is not necessarily better than the other. Because exponential moving averages have less lag they are more sensitive to recent prices and price changes.
Another subtle feature by using EMAs is that you’ll see the chart turn quicker when a price reverses direction.
On the other hand, simple moving averages represent a true average of prices for the entire time period. So if you want to identify support or resistance levels, simple moving averages may be a better choice.
Identifying the Strength of a Trend. One thing I know to be true in the trading world is this: the farther the price is away from the moving average, the weaker the trend. A weak trend translates into a trading opportunity - a potential reversal is on the horizon. Armed with this information, combined with other indicators like volume, you're well on your way to executing a winning trade.
Identifying the Direction of a Trend. The direction of the moving average tells us important information about a stock price. A rising moving average means prices are rising. Likewise, a falling moving average indicates prices, on average, are falling. A long-term uptrend is characterized by a rising long-term moving average. Hence, a long-term downtrend is characterized by a falling long-term moving average.
Identifying Trend Reversals with Crossovers. Like I mentioned above, typically a weak trend means a reversal is coming and crossovers help to confirm. After an uptrend, for example, if the nine-day MA crosses below the 50 day MA, then the bullish trend may be reversing, signalling the start of a bearish trend. Be advised though, there tends to be frequent fake-outs with crossovers that catch new traders off guard. For these reasons, you should always confirm reversals using other methods and tools.
Identify Entry and Exit Points. Not only are moving averages used to identify trends, but they are powerful buy or sell indicators. One of the simplest strategies out there utilizes the crossing of two or more moving averages as an entry/exit trigger. Your basic signal is when the short-term average crosses above or below the longer-term moving average.
I use the 9 and 20 exponential moving average indicators on my charts. The crossing of these lines signifies a shift in price direction; it's as simple as that. Now you have the option to use the 13 EMA as well. It all depends on what you're comfortable with. Personally, I'm using the 9/20 EMA crossover to verify my entry and exit points.
I highly suggest having multiple MA lines with differentiating time frames displayed on your chart. Personally, I use the 9, 50, and the 100-day MA as it gives me a birds-eye view of the market, which helps me to identify stronger trends and possible reversals.
When I'm going long on a stock, I want the candlesticks to be above the 50 SMA (simple moving average). Likewise, when I'm going short on a stock, I want the candlesticks to be below the 50 SMA.
As you know, or soon will, people are always eager to help out a new trader; which can be nice when learning how to use moving averages to trade trends.
I have the habit of writing down tips I’ve received along the way. I thought I’d share them with you. Now it’s up to you whether or not you want to follow them but they may help.
Do you know how to use moving averages to trade trends? Moving averages are powerful trading tools every trader should have in their toolbox.
Their greatest strength is its ability to help a trader identify a current trend or spot a possible trend reversal.
And they can also define a stock’s level of support or resistance, or act as a simple entry or exit signal.
Having said that, how you choose to use moving averages is entirely up to you. But all things considered, you’d be wise to incorporate them into your trading strategy.
For further information on moving averages and how to trade them, check out our free online trading courses.