Examining the Uses and Benefits of Moving Averages in Stocks - dummies

Examining the Uses and Benefits of Moving Averages in Stocks

By Greg Schnell, Lita Epstein

Moving averages help clarify a trend starting and finishing. The direction of the stock’s moving average is important as it signals the trend. When a moving average starts to point down, the price has moved below the moving average. This change of direction from up to sideways or down is usually a subtle clue that the trend is changing rather than just being a pullback in an uptrend.

Knowing when to move in and out of a stock

Using the moving average tool to smooth the trend is a simple way to maintain a strategy for the trader who wants to move in and out of a stock and stay in a rising trend during pullbacks. Recognizing a change in the direction of the moving average is a strong clue that what has been working is starting to weaken and may be signaling the end of a trend.

Using two moving averages can add additional clues. A short-term moving average crossing below a long-term moving average clearly illustrates a trend change. When both short- and long-term moving averages are pointed in the same direction, the trend is strong.

Because moving averages are commonly used in technical analysis, they can be important as a place where falling stocks bounce after pulling back. When stocks are in a downtrend, the moving average can be a place where a bounce in the stock price stalls and the stock moves lower again.

You can use two moving averages to help you sell, and you can use two completely different moving averages to help you buy. You can accomplish this by having multiple chart styles that enable you to move quickly between them. There is no perfect system, so you need to find one that works for you.

Whatever your trading strategy is for using a single moving average, multiple moving averages, or the signals created by the moving averages crossing over, there will always be times when the trade is moving against you.

Finding entry points

Moving averages are also a major tool for finding nice entry points. When a stock goes above a moving average that you use, this can be used as a buy signal for your time frame. A stock that bounces up off a moving average can also be used as a place to buy an initial position or add to a position that is working.

When the stock fails to hold above a moving average that has supported the stock in the past, it can be a clue that major institutions are no longer buying dips in the stock.

Moving averages are used to help keep a bias toward the stock. When stocks are under a long-term moving average (200 MA), it is usually a good idea to avoid owning them. As an investor, you can choose to own only stocks above the 40 WMA or any other moving average you think prudent. For most investors new to charting, that is a radically new way to think about owning stocks.

The most common moving averages for multiple-month investing would be the 50 DMA and the 200 DMA. For shorter-term investing, the 20 DMA may be more suitable. Traders using 5 DMA and 8 DMA are trading often.

Picking the right moving average for you

If you’re a new investor, look at different moving averages on a chart. If you want to place trades only occasionally, you need to find a moving average time frame that gives you those types of signals. By placing four or five moving averages on your chart, you can establish which time frame is more suitable for you.

For example, active investors who want to trade frequently would use a shorter moving average to match their trading style, such as the 20-day MA. When price moves above the 20 DMA, they buy, and when it moves below, they sell. (You can imagine someone trading on five-minute charts with a 20-period MA is going to make a lot of trades — not recommended.) If your trading style is active and you want to be buying and selling every few days, making trading decisions on a 40 WMA is not going to work for you. It won’t be active enough for your desired trading style.

If the price is crossing the moving average on a chart too often, you need to use longer moving averages. If the price is crossing the moving average on a chart too infrequently, you need to use shorter moving averages. Because there are many styles of investing and many different personalities in trading, you need to find a moving average time period that works for you.