Moving averages provide an easy visual reference to see in which direction a share is trending.
A simple moving average (SMA) is calculated by adding up the closing prices of several periods and then dividing that value by the number of periods added up.
The table illustrates the calculation of a five-day moving average.
By summing the daily closing prices for five consecutive days and dividing that value by five, you arrive at a single data point that represents the average value of the last five days’ closing prices.
To create a moving average, keep doing this calculation for each consecutive day, always looking back five days and using the five previous closing prices to calculate the five-day average.
A very simply calculation, then. When expanded to include 100 data points, you can clearly see the SMA follows the share price in a smoothed sort of fashion, indicating more easily what the overall trend is.
But the price chart was easy enough to read, so what’s the point?
Well, you can see that when the share price is trading above the moving average, the share tends to trend higher.
Conversely, when the share price is trading below the moving average, the share price tends to trend lower.
This then allows you to very quickly see the trend of the stock without having to look for primary, secondary and tertiary trends.
You can also see that when the price crosses over the moving average significantly, it is followed by a change in the direction of the trend.
Traders and investors can thus use moving averages to give them signals to buy and sell shares in anticipation of these changes in the underlying price trend of the share.
Traders must be cautious, though, to not use too few data points to create their moving averages.
Five days is not very much data and the moving average might intersect with the price very often, thus creating false trading signals.
These days, practically every trading platform that stockbrokers give clients can draw in these moving averages, so that there is no need to calculate them manually, but it is helpful to understand how they are calculated.
As usual, there are three different timeframes in which investors and traders can think.
Short-term moving averages: created by using fewer than 50 data points.
Price crossovers and intersections with moving averages ranging from 7 to 21 days can be considered very short-term signals, while crossovers and intersections with moving averages from 21 to 50 days can be considered short-term.
In both cases, the trends they signal are generally tertiary trends (sometimes secondary trends) and are not expected to last very long.
Medium-term moving averages: created by using 50 to 100 data points.
Price crossovers and intersections with moving averages ranging from 50 to 100 days can be considered medium-term signals and anticipated trend changes are expected to last somewhere from a few days to a few months.
Similar, of course, to secondary trends.
Long-term moving averages: created by using more than 100 points, with 200 days being considered the standard to evaluate long-term trends.
Price crossovers and intersections with moving averages above 100 days can be considered long-term signals and anticipated trend changes are expected to last somewhere from a few months to a few years, as is the case with primary trends.
Trading strategies can be built around using moving averages as signals.
Take, for example, a very simple medium-term trend change signal that uses three different moving averages.
The rules of this strategy are very simple: If there is a bullish crossover of the 50 SMA and 100 SMA (in other words, if the 50 SMA crosses over the 100 SMA from below), while the share price is below the 200 SMA, a buy signal is generated.
The buy signal is confirmed when price performs a bullish crossover of the 200 SMA, and the stop-loss is placed at the previous low.
As the trade works in your favour and the share price makes new highs and new lows, move the stop-loss up by one low, each time a new high has been formed.
The idea behind the strategy above is to seek out shares that are undergoing longer-term trend changes and then to buy the shares around the point where the trend is changing.
There are very many other ways in which moving averages can be combined and used to generate trading signals.
Investors, traders and budding analysists alike are encouraged to play around with and test different moving average time periods on share prices to come up with a combination of moving averages that works for them, as well as for the individual share or instrument they are trading.
Petri Redelinghuys is a trader and the founder of Herenya Capital Advisors.