Stock trading requires you to make use of profit opportunities that emerge from the way prices move. Traders use specific technical indicators to study price movement and opportunities that arise from them. One of the most popular and reliable technical indicators is the moving average. It is the average of the closing prices over the given period. The averaging out helps smoothen the price information and distil the noise of daily price changes.
There are short term moving averages like the 10-day moving averages or 7-day moving averages or long term moving averages like 200-day moving averages. A 200-day moving average, for example, is the average of closing prices of the last 200 trading days. All these are quite useful for indicating price trends and providing a trend line to place potential support and resistance.
Removes Impact of Daily Price Fluctuations
Moving averages remove the chaos of daily fluctuations in prices from the stock chart. On the price chart, it looks like a trend line, giving the trader a quick glimpse of the price trend.
Direction of prices
If it is an upward trending moving average, prices are likely on the rise, but if it is a sharp uptrend, then prices might be peaking. If it is a downtrend, prices are on a decline. A sharp downward slope, however, may indicate prices have bottomed out.
A trend line moving sideways indicates a range-bound movement in prices. Usually, when real-time prices are above the moving average (MA), it signals an uptrend, and when prices are below the MA, you will see prices being pulled in the downward direction. Two moving averages of different durations may merge and cross each other in opposite directions, as will see later.
How to Use a Moving Average to Buy Stocks: Support or Resistance Level
Medium to long term moving averages like 50-day or 200-day ones double up as popular and reliable support and resistance levels. These points on the moving average are relatively challenging to breach. That makes it more effective as a signal to buy or sell a stock when prices touch the support and resistance levels. In a trending market, prices move within a range. They usually bounce off the support level on moving averages or pull back from grazing the resistance level. These levels are again only breached with sufficient buyers or sellers coming in. This allows for a reasonable holding period.
Moving Average Crossover Trading Strategies
50-day moving average of BSE Sensex (purple) crosses over its 200-day moving average (yellow).
In one of the popular trading strategies, traders use a combination of short-term moving averages like 50 days and long-term ones like 200 days as trend indicators to test the bullishness of the stock.
Like you see in the price chart of BSE Sensex above, if a stock’s 50-day MA jumps over a 200-day MA, it is called a Golden Cross in stocks. It signals a bullish turn in sentiment. Here, you will also find the shares touching the support levels on the long-term moving average, indicating that prices may have bottomed out.
Moving averages have often been criticised for having a lag effect. That is, they show a trend based on past prices. But they serve few important purposes of distilling daily price changes for a smoother indication, offering strong and reliable levels of support and resistance. Understanding how to use moving averages is useful for traders to enter in and buy stocks or take short positions.