The Moving Average
A Simple But
The moving average (MA) is a very simple but powerful tool that you should use. MA's simply smooths the data so that we can do our analysis easier.
A MA is the mean of a given set of value. For example the 10 day MA is calculated by adding up the closing prices of the stock from the past 10 days and then dividing it by 10.
There are many types of MA's. We will use the simple MA. Remember? Keep it simple.
Here are the uses of MA's...
Identifying and confirming a trend
A moving average is a lagging indicator. What this means is that they do not predict the future, they only confirm a trend once it is established.
In order to determine the trend, we will look at the location of the MA and the direction it is moving.
When the price of a stock is above the MA, the stock is in an uptrend. When the price of the stock is below the MA, the stock is in a donwtrend.
When the MA is rising, the stock is considered to be in an uptrend. On the other hand, when it is declining, the stock is considered to be in a downtrend.
Take a look at the chart below.
Lesson: Turning knowledge into gold...
To make money, only buy a stock when it is in an uptrend(when the stock price is above the MA and the MA is sloping upward).
Sell(or short) the stock when it is in a downtrend(when the stock price is below the MA and the MA is sloping downward).
Support and resistance levels
Moving averages can act as support and resistance. The idea is that a MA can stop the decline of a stock(support) or act like a ceiling halting the rise of the stock(resistance).
This is actually a subjective support and resistance. However, because so many people believe it to be true, it usually turns into a self fulfilling prophecy.
The most popular MA's used as support and resistance is the 50 period(day) MA and the 200 period(day) MA.
The above weekly chart of the SPY(S&P 500 Depository Receipts) shows how the 50 period and 200 period MA's can act as support and resistance.
Insight: Turning knowledge into gold...
There are some investors and traders who use the strategy of buying a stock when it reaches its 50 or 200 day MA's. This strategy can be quite profitable when you combine it with other anaylsis.
For example, there is a double bottom forming at the 50 day moving average and there is a hammer candlestick pattern forming at the second low. A presence of a divergence in the MACD or RSI confirms a good trade...Fundamentals still strong...and market breadth and internals point to a rally...and the market is oversold...
Sounds confusing right? Don't worry. When you finish the rest of the Basics, Intermediate and Advanced you will be able to do a proper analysis and know when to enter or exit the stock.
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