You should know what moving averages are from your previous studying, but if you don’t, they are the average value of the last so many days of values, and they smooth the prices out so that you can see better which way and how much they are moving. They are called moving averages, as they move each day – the oldest value is dropped off, and the newest picked up, to go towards today’s moving average.
If you remember, there are two types of moving average – the simple moving average (SMA) which is just an ordinary average as we know them, and an expo-nential moving average (EMA) which adds more significance to recent data (makes it closer to the current value). Actually, there are some other types, but I won’t bother to explain them here, as these are all we need for our trading.
The number after the average is how many days (or time periods, if you’re using something other than a day) are averaged. It’s unusual to see anything other than a day used in this context, though. You always need to remember the use of all these lines, so we’ll go over it now. The principle is that when a line or price crosses another line, which is a definite and unambiguous signal, we can relate it to a particular action that we want to take.
The shortest term average I use, SMA 20, which I like to colour red, is the signal to open a trade. The trade will be long or short, depending on the trend. For example, when the trend is up and the price is above the red line, I look at opening a long trade, buying the stock.
The next average, SMA 40, the 40 day average, I usually make green. This is a very useful line, as it shows us when to get out of the trade. It gives us a moving stop loss, and if we have a stop loss in the market, then we should move it according to this line. Generally, that will automatically lock in our gains. If the price goes below the green, the stock is sold and we have our profit. If we are shorting the stock, the green still gives us the signal, but obviously it’s when the price goes above.
Just to digress again, I think that people place too much emphasis on finding a perfect ‘entry’, that is, the absolute ‘best’ time to buy. You have to remember that you don’t make a profit (or a loss) until you sell, and you need to pay attention to your ‘exit’ so that you maximise your opportunity. SMA 40 is a great basic indicator of an exit point, and you will also become familiar with others to enhance your trading performance.
The first two lines give us signals for action, and can be used on their own for trading, although I like to use other factors to confirm the trades. On the other hand, the third line, SMA 60, which I colour blue, gives us information. Normally, in an uptrend, the red and green are above the blue. If they come down and cross this signals a change in the trend, and we would think of trading short rather than long. We wouldn’t be in the market anyway when this happens, because the green would have stopped us out, but if the reversal continues, our next trade signalled by the red line would be short. The opposite applies if we are going from a bear or down trending market to a bull market.
And the EMA 200? This line I usually colour grey and make it dashed. This is the last moving average that I use, and it just confirms the trend. When the other three lines are above this average, it means that the uptrend is established. This is because 200 days is a long enough time to establish the direction of the predominant trend.
You can experiment with the time periods on each of these, to see what the effect is on the signals. Some stocks respond better to using a different number of days for the averaging. You can even try swapping between the simple moving average and the exponential moving average, until you find the one you like the action of best.