A very popular way of identifying trends is through the use of moving averages. A moving average is an indicator that smoothes out price action by calculating an average of closing prices over a period of time and displaying the result as a line on a chart.
Here is a simple example of a moving average on a chart.
There are two variables to be determined when using a moving average.
First, you need to decide on the time period you are going to use to obtain the average and, second, what method of averaging you are going to use.
Let me spend just a moment with this first variable. For as long as people have been talking about trading, people have asked about what the best moving average period is to use. There isn’t any!
One of the main reasons why people use a moving average, myself included, is to assist with determining the trend. The period of time we use for my moving average should be based directly on the type of trend we are interested in identifying.
For example, someone who is interested in short term trends (5-15 days) would have little use for a 200 day moving average. Similarly, someone who trades medium terms trends (several months in duration) is not likely to have much use for a 5 day moving average.
The time period you select should match the time period you are trading.
If you are interested in medium term trends (eg. 2 months), then perhaps a 40 or 45 day moving average would be best for you. Why? The resultant moving average line depicts the present medium term trend. Please note that 2 months is approximately 40-45 days and NOT 60 as you would think. Stock markets are not open on weekends and therefore the data for your charting software has only 5 days per week and not 7.
Here is an example of another chart with a 45 period moving average plotted.
The precise you number you choose to me is not that important. Even though I have used a 45 day moving average in the chart above, I could have easily used a 44, 45, or 46. The chart below has all 3 plotted. You will see that there is little difference between the 3 and so far as practical trading is concerned, there is no difference.
Some people will use numbers from the Fibonacci sequence for their moving averages.
|Leonardo Fibonacci (c. 1170 – c. 1250), aka Leonardo of Pisa, was an Italian mathematician. He is best known for the discovery of the Fibonacci numbers commonly referred to as the Fibonacci sequence. Some people consider him the ‘the most talented mathematician of the middle ages.’|
After two starting values, each number is the sum of the two numbers before it. The first Fibonacci numbers are:
0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, 233, 377, 610, 987…. (and the list goes on to infinity)
You don’t have to limit yourself to using just one moving average. Why not use more than one? The chart below shows 3 different moving averages of different time frames. They are a 10 day, 60 day and a 200 day moving average. Using two or three moving averages of different timeframes can give you a broader assessment of the price’s direction.
In the chart above, you should be able to tell which line is which. A shorter time frame moving average (one that uses a smaller number of days in its calculation – in the chart above, this is 10 days), will be more sensitive to the immediate price and, thus, will always stay closer to the bars than a longer moving average.
The line furthest away from the price and underneath the price at all times is, therefore, the 200 day moving average. The line in between those two is the 60 day moving average.
The simplest way to use moving averages in your trading is to note the recent direction of the indicator. You will notice that the 10 day moving average, in this case, has just turned up and therefore indicates that the short-term trend is rising. The other two moving averages have both been rising for some time now.
All of the examples shown up to this point are known as ‘simple’ moving averages. The mathematics behind a simple moving average is quite simple.
For example, a 30 day simple moving average means that to determine any day’s moving average value, the previous 30 days’ closing prices are used (all added up and divided by 30). As a consequence of its calculation, a moving average is referred to as a lagging indicator.
There are other types of moving averages, such as exponential and weighted moving averages. These place greater emphasis, or weighting, on more recent data. In contrast, a simple moving average gives equal consideration to all days used in the calculation. The end result is that a 30 day exponential moving average will react more quickly to a share price’s recent performance than a 30 day simple moving average.
This is shown in the chart below with the simple moving average in black and an exponential moving average in red.