Before we get into the application of the moving average in buying stocks, it would be prudent to define the concept first. The moving average identifies reversals and trends, measures an asset’s momentum strength and also determines potential areas for an asset to locate resistance or support. It is seen and established that varying time periods monitor momentum and moving averages can set stop-losses.
Identification of Trend
Trend identification is a primary and key function of moving averages. This is used by a large number of traders who wish to befriend trends. Moving averages happen to be lagging indicators, i.e they don’t predict any new trends. Instead, they confirm trends when they are established. A stock becomes an uptrend one when its price goes above the moving average which slopes upwards. Conversely, traders take recourse to a price that falls below a sloping average that is downward to confirm downtrends. It is also often seen that traders only hold a long position in any asset when prices trade above the moving average.
Many novice traders are often curious about the measurement of momentum and how a moving average may be applied to achieve it. The answer is simple. What one needs to do is to pay attention to time periods that are used to create the average. Every single time period provides valuable insights into different momentum types. Generally speaking, short-term momentum is measurable by taking into consideration moving averages over twenty or lesser number of days. Medium-term momentum is measurable from moving averages created within a span of twenty to one hundred days. Similarly, long-term momentum can be measured using moving averages over one hundred days or more. The common thumb rule is using a fifteen day moving average to measure short-term momentum.
A proven method to ascertain the direction and strength of the asset’s momentum is by placing 3 moving averages on a chart and then analysing how they relate to each other. These 3 moving averages are taken from price movements taken from the short, medium and long-terms.
Moving averages are also commonly used to determine potential price support. It is often seen that while applying moving averages, the dipping price of a particular asset often stops and reverses its direction at the identical level of a notable average. For instance, a two hundred -day moving average is generally able to prop up a particular stock’s price after it dipped from its highest level. Many traders anticipate bounce offs on the notable moving averages and resort to other specialized technical indicators to confirm an expected move.
If an asset’s price dips below a powerful support level in the long term, it is usually seen that the average acts as a powerful barrier preventing investors from raising the price to above the average level. Traders often take this resistance as signs to book profits or close out any long positions that may already be existing. Short Sellers also make use of these averages to make entries as the price may often bounce off such resistance and continue to keep dipping. As a long position holder of an asset that keeps trading below the most notable moving averages, you definitely need to keep a close watch on these levels as they stand to affect your investment’s value greatly.
The two main characteristics of moving averages — resistance and support — make the latter a most effective tool for risk management. Moving averages have the ability to locate strategic points for setting stop-loss orders that allow traders to exit losing positions prior to more damage being done. Traders holding long positions in stocks who set stop-losses below influential and the notable averages can thus save plenty of money. And that’s exactly why moving averages are so important to frame successful trading strategies.
In sum, it goes without saying that moving averages are an inextricable part of any trading strategy and over time, have proven again and again to be one of the most effective tools of risk management. Particularly in volatile markets, they help prevent financial losses to retail investors who stand the risk of losing heavy sums of their hard earned money by way of the stop loss mechanism.