Moving Averages are the most fundamental indicator of all stock analysis technical indicators.
In fact, performing any type of profitable investing activity would be extremely difficult without the use of moving averages.
When you look at a chart of stock prices the one thing that immediately jumps out at you is the seeming randomness of price movements. Sometimes there doesn’t seem to be any trend in the way prices vary. One extremely useful analysis technique is the use of moving averages of the price data.
Moving averages are named after the way they are constructed; moving averages – or MA’s – don’t move in the physical sense. They move along with the price of the stock as time passes.
Their main help is to smooth the price data so it becomes easier to discern price trends.
Moving averages don’t predict price direction but they do project critical information about where prices have been. And stock prices by their nature frequently move in trends – and that is the information you need for a profitable investment strategy.
This article will discuss how MA’s are developed, their uses in profitable investing, and will provide an example of their use on a real stock chart.
How moving averages are developed.
Moving averages are calculated by adding up the closing prices of the stock and dividing by the quantity of prices in the calculation – just like an average of any other variable. The difference is that for MA’s the calculation drops the oldest closing price and adds the most recent closing price to the total before dividing.
So the moving average updates or provides fresh insight into stock prices as time goes by.
Lets look at the calculation of a 5 Day moving average with closing stock prices of: 11,12,13,14,15,16,17
First day of 5-day SMA: (11 + 12 + 13 + 14 + 15) / 5 = 13
Second day of 5-day SMA: (12 + 13 + 14 + 15 + 16) / 5 = 14 (drops the 11 and uses 16)
Third day of 5-day SMA: (13 + 14 + 15 + 16 + 17) / 5 = 15 (drops the 12 and uses 17)
So from this simple example you can see that the 5 Day moving average has moved up from 13 to 15 over a period of 3 days. This is an example of a “simple” moving average. There are other ways to perform the calculation such as applying more weight to more recent prices but for our profitable investing use the simple MA is quite effective.
As you probably realize, moving averages can be any length and for any time period of stock chart.
There can be any number of closing prices used, 5 as shown above, 10,20,50,200 etc. However, the most effective length for the profitable investing strategy is the 50 period MA.
It isn’t that the other lengths aren’t useful, its just that the 50 period MA is fast enough without being too fast, and slow enough without being too slow. We want to get into a stock trend early enough to make a profit and get out when appropriate – and the 50 period moving average is just right for active stock investing.
Profitable investing makes us of the daily MA, the weekly MA, and sometimes the 15 minute MA when deciding when during the day to place an investing order.
How moving averages are used for profitable investing.
When moving averages are plotted on a stock chart they form a line on the same scale of the closing prices. We can use this information (among other analysis techniques) to decide if the stock trend is in our favor or not.
As a general concept the following rules can apply when observing moving averages on a stock chart of any period. For this type of analysis you need to picture an arrowhead on the last part of the moving average line.
If the MA is moving up you can expect stock prices to be in an uptrend, especially if prices are above the moving average.
If the MA is moving down you can expect stock prices to be in a downtrend, especially if prices are below the moving average.
If the price is relatively flat you can expect stock prices not be in a trend
As always there are exceptions to every rule, that’s why profitable investing advocates strict use of stop orders as outlined in how to sell stocks.
Moving Average example stock chart
GNC – Moving Average Example
Here is a stock chart of GNCs stock price performance during 2013. GNC is the largest global specialty retailer of nutritional products and is headquartered in Pittsburgh PA.
This chart is a great example of how the 50 day moving average can help identify an uptrend and identify optimal buy points along the way.
In February of 2013 GNC turned around from a downtrend and started significantly outperforming the market. The move up from the base in late February marked the top of the price channel that lasted through 2013.
At the time of the breakout, GNC moved above the 50D MA at just about the time the moving average started to point upwards. A return from the high of the breakout to the support of the 50D MA was a first buy point and marked the lower channel line of the 2013 price increase.
During 2013 GNC created lower lows right at the support of the 50D MA and the lower channel trend line. In fact, GNC came back to optimal buy areas near the 50D MA numerous times during the year.
Astute investors who recognized GNC as an outperforming stock early in 2013 could have taken advantage of a move up from about $30 to $60 – a doubling of an investment in less than a year!
This example shows how the 50 day moving average can not only help identify stocks in an uptrend but can also help identify optimal buy points that can lead to extremely profitable investing.
Read more on how to buy stocks, and how to sell stocks.