Moving Averages 101
What is a Simple Moving Average?
Investopedia.com defines a simple moving average (SMA) as: “A simple, or arithmetic, moving average that is calculated by adding the closing price of the security for a number of time periods and then dividing this total by the number of time periods. Short-term averages respond quickly to changes in the price of the underlying, while long-term averages are slow to react.” Moving averages can be defined in virtually any time frame but the two most common are the 50 and 200 day moving average (DMA) lines (a.k.a 10-week and 40-week moving averages).
Most Common Moving Averages
As defined, the 50 and 200 DMA lines simply look at the past 50 or 200 days and a line is drawn to illustrate the average close during that period. In a healthy uptrend, one would like to see the both moving averages slope higher and for the 50 DMA line to reside above the longer term 200 DMA. Conversely, when the 50 DMA turns lower, or actually slices below its longer term 200 DMA counterpart, this is usually a sign of weakness- or a change in trend. Some technical trading systems flash buy/sell signals when either moving average “crosses over.”
Other Moving Averages:
Several studies show that leading stocks (or markets) tend to pullback and find support at their respective 10 and 21-day moving averages before resuming their prior trend. These are shorter term moving averages and tend to be more volatile in nature. However, they are still an important way to gauge the underlying health of a stock (or market) and are used by some investors as a healthy area to accumulate a position. Another important intermediate term moving average is the 150-day moving average (30-week). The 150 DMA is an important gauge that defines the intermediate term health of a stock (or market). There are several other moving averages that are used but they are outside the scope of this article. If you are interested in learning more about these moving averages or other topics- pls send us an inquiry on our contact page.
Price vs. Moving Averages
The simple premise is that if the price of security (or market) is trading above a moving average then the action is healthy and if the price is trading below an important moving average then the action is not as healthy. It is also important to note that it is healthy to see a stock (or market) move back to a moving average on light volume during an uptrend (converse is also true) and then bounce off that moving average on higher volume (ideal scenario). This natural occurrence is actually considered healthy as most leading stocks (and markets) tend to do this during a protected uptrend. That said, moving averages offer prudent investors a healthy chance to accumulate a position as the underlying investment pulls back to a logical area of support. However, a technical sell signal will be triggered once an important moving average is broken (especially if volume is heavy) and that is an important warning sign most investors should look for.
Simple Rule of Thumb:
As a simple rule, one should only look to go long (buy) when the underlying price is above an important moving average and go short when the price is below an important moving averages. This is the basic rule, but of course, like any rule, it is important to know when it is o.k. to break that rule!
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