If predicting the changes in the price of stocks and commodities were easy, everyone would be a market millionaire. As it is, predicting future prices with certainty is impossible, but techniques have been developed to put the odds in the investor's favor. While some of the more intimidating approaches rely on complex relationships and mathematical computations, the moving average is a simple indicator that can be used to help plan profitable trades. Simple moving average, or SMA, is a common tool used to flatten out short-term volatility and indicate trends. SMA is smoother and slower-moving than the mathematically more complex exponential moving average (EMA), which can potentially offer more data, but also more statistical "noise." Both are, nevertheless, excellent tools for judging support and resistance in multiple time frames.
Use an interactive charting platform. Some brokerages offer their own proprietary charting platforms, and independent charting software can also purchased and downloaded. Free charting services are also available online.
Choose a stock, index, commodity, currency or any other investment vehicle to chart, and the time frame(s) to examine. Use a time a frame that matches your goal for investing or analyzing a particular vehicle. Looking at a daily chart for a long-term investment will not be effective, while a weekly chart stretching back for years will only rarely provide useful information for an intraday trade.
Use your charting platform to overlay common moving average intervals, typically 5, 50 and 200. Most charting services offer instructions or tutorials for this step.
Look for clear support, resistance and crossovers on the moving average intervals selected. If satisfactory results are not achieved, adjust the intervals or the time frame.
If a particular moving average is acting as support, buy orders can be placed at or near that level with stop-loss orders slightly below. If a moving average is acting as resistance, sell orders can be placed at that level with stop-loss orders slightly above. If a crossover occurs, the existing relationship, either support or resistance, is likely to reverse.
Tips & Warnings
- Incorporate moving averages into an existing trading or investing approach. While this technique can be used in isolation, other techniques may confirm or alter your decision to enter or exit a trade based on this technique alone.
- Be disciplined! The purpose of using technical analysis, including moving averages, is to take emotion out of trading and increase odds of success. Buying on a dip or selling in a rally may feel counterintuitive and counter to current sentiment, but an existing moving average relationship provides a relatively low-risk opportunity for attempting a contrarian trade. The most important part of discipline here, though, is to honor stop-loss levels. As the chart suggests, moving average relationships do not last forever, and it’s the quick confirmation and ability to limit losses by exiting a busted trade that makes this technique relatively low risk. Moving averages tend to work best within a trending market--highly volatile markets may be difficult to navigate using moving average alone.
- Photo Credit created by author at Stockcharts.com
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