Technical analysts often say, "The trend
is your friend," because they think
a security that's going up, is more likely to keep going up.
And a security that's going down,
is more likely to keep going down.
Having a clear view of the trend can
help an investor decide whether to buy, sell, or hold
a position.
However, sometimes determining the trend can be difficult
and that's why this video is so important.
A simple moving average is a technical indicator, or tool,
that tracks a security's price over a time period
and plots it on a line.
This essentially "smooths out" price fluctuations
to give an investor a general idea where
the trend is heading.
Using simple moving averages to determine trends,
an investor can better identify buy and sell signals.
To create a simple moving average chart,
start by choosing a time frame.
A frame can be any period of time--
including a day, a week, or even a month.
For this example, we'll define a period as a day.
Let's create a moving average using a 20-day chart.
We'll take each day's price, then add them together.
Then we'll divide that number by our time frame number,
which in this case, is 20.
This gives us today's 20-day average price,
which is a short-term moving time frame and one
that active traders may use.
To create a moving average, each day we'll drop the last day
in the time frame and add today's.
A 20-day moving average can help determine
short-term up trends, down trends, and sideways trends.
Examining a security's moving average in relation
to its current price, can help investors
identify potential buy signals.
For example, when a price breaks above an upwardly sloping
moving average, this could mean it's a good time
to buy a stock.
Another buy signal could be a support bounce.
This is when a security's moving average acts as a support
level for the price.
When the price comes down to the moving average,
and then rallies up again, this bounce
could be used as a buy signal.
On the flip side, moving averages
can also help investors know when to sell a position.
For example, if the stock's price
rises to the moving average and bounces,
this might be a sell signal.
Looking at a simple moving average over a short-term time
frame can be very helpful, but it has its drawbacks.
One thing to be aware of is whipsaws.
A whipsaw is when the stock crosses over the moving
average, giving one signal, and then reverses quickly,
giving the opposite signal.
A short-term time frame, like 20 days,
usually shows more whipsaws, which
is why some investors may prefer to use
intermediate and long-term time frames.
For example, intermediate term charts with a 50-day moving
average, show a smoother average and have fewer buy
and sell signals.
As a result, the investor may stay in the trade longer.
Long-term trends, like those found with a 200-day moving
average, are even smoother.
When looking at all these averages together,
we can see that the short-term average
is confirmed by the intermediate and long-term averages.
The main disadvantage of any simple moving average
is that they're slow to reflect price changes.
Because each period is given equal weigh,
day 50 counts as much as day one.
As you can see, a large gain or drop
hardly factors into a moving average for some time.
This is known as lag.
Let's look at an example to illustrate this.
If you use a simple moving average for buy and sell
signals, your stock could experience a huge pullback,
well before the simple average reflects this activity.
To avoid lag, consider using another analysis,
such as a weighted moving average or exponential moving
average.
These types of moving averages consider recent data
the most relevant and give it more weight.
Consequently, these types of moving average lines
react quickly to the securities price changes.
This is helpful for active traders who want
to place short-term trades.
It's also important to note that moving averages don't
predict future performance, they only
confirm established trends.
Even with these drawbacks, moving averages
are a powerful tool of technical analysis
that can help you determine trends and identify
buy and sell signals.