Moving averages help traders by providing an easy, visual method of knowing where the price is moving in relation to the trend.  Moving averages let you know when the trend is up, when that uptrend starts to slow down and eventually, when it starts to reverse.

Moving averages are calculated by averaging the stock price over time.  By averaging the stock price and putting it on your stock chart, the daily erratic stock price movements are smoothed out into one connected line that you can easily reference.

Basically moving averages help you to determine whether the stock is in an uptrend or a downtrend.  When the moving average is going down and the price is below the moving average, the trend is down.  If the moving average is going up and the price is above it, the trend is up.  If the trend was up and the price moves below the moving average, it might be time to sell.

Let’s look at the different types of moving averages with examples:

Simple Moving Average (SMA)

The simple moving average is the most commonly used, simply because it’s simple.  It is calculated by adding up the stock’s closing prices and dividing that number by the number of time periods.  For example, a commonly used moving average is the 50-day moving average.  To calculate the 50-day moving average, the last 50 closing prices are added up and the sum is divided by 50.  Don’t worry, you don’t have to actually do all of these calculations yourself.  Every charting site or program has this function built in.

The average is less responsive to price changes if it is calculated over longer time periods.  If you select a longer time period, you are looking at longer-term trends.  If you are using a shorter time period, you are looking at shorter-term trends.  Let’s look at some variations of simple moving averages in action:

As you can see, the shorter-term moving average (50-day blue line) is much more responsive to price changes than the longer-term (200-day red line) one is.  Let’s say you bought the stock at the start of January at $170 when the stock price rose above the 50-day moving average, signaling a new uptrend.  4 months later, the stock is up to $260, a 53% gain.  Naturally, you are tempted to sell it since you’ve made a good amount of money on paper and you don’t want your paper profits to disappear.  On the other hand, it’s been a winner so far.  Maybe you’re tempted to hold onto it and see what happens?

Taking a step back, it’s beginning to show signs that the up-trend has leveled off, so naturally you’ve become cautious.  Let’s add in a 20-day moving average and see what the averages are telling you.

If you strictly went by the 20-day moving average as either a buy or sell signal since January, you might have sold it in late February or early March.  The uptrend continued on though after brief blips under the 20-day moving average, so these would have been false sell signals.  In late April the stock price fell below the 20-day moving average but only stayed there for a day and a half, not really long enough for concern.  Going into May we’ve got 3 days below the 20-day moving average and finally on May 4 th the stock price broke through the 50-day moving average on heavy volume.

Did it the 50-day moving average catch the trend reversal fast enough?  By the time the stock price dropped below the 50-day moving average, you already lost almost 20% from the peak.  Going by the 20-day moving average, you might have already sold twice on the run up and missed out on a large portion of the uptrend.  What do the pros do in situations like this?  Is there another type of moving average that would have given you a better signal more quickly?

Exponential Moving Average (EMA)

The exponential moving average was created to catch trend reversals more quickly.  The exponential moving average differs from the simple moving average in that it places more emphasis on the more recent time periods, whereas the simple moving average does not take recentness into consideration.  This makes the EMA more responsive to trend changes.  Let’s look at the same chart we were looking at with exponential moving averages instead of simple moving averages on it and compare the differences:

Going back to our earlier example, the exponential moving averages do catch trend changes more quickly that simple moving averages but in this example, it didn’t really make a difference as far as when the price drops through the moving average.  It still happens at the same time.

Let’s look at a close-up of the same chart showing the 20-day simple moving average (red line) and the 20-day exponential moving average (blue line):

Looking at the EMA you can see that it started to turn downwards before the SMA did.  As we saw previously, selling the instant the stock price crossed below either the 20-day SMA or EMA would have resulted in you getting out of the stock earlier and missing out on a large portion of the uptrend.  Ultimately, it doesn’t matter whether you’re using the simple moving average or the exponential moving average.  They are both showing you the same thing, they just come to the calculation in a different way.

So what do the pros do?

The pros look for some type of confirmation before acting on what the moving average is indicating.  The confirmation that they are looking for filters out the false signals that would have led you to sell too early.  The filter could be either a percentage move in price, or a certain length of time.  A 10% move below the 20-day moving average is a commonly used sell signal and is certainly a good filter to use in most cases.  In this case it would result in you selling on the 4 th of May, down about 20% from the peak in mid-April.  Another good filter to use would be a time filter.  If you were to sell on any three-day move under the 20-day moving average, you would have sold on the 3 rd of May and had around 10% more money than if you had sold on the 4 th .  But you still could have done better.

Pairing Moving Averages

The pros don’t just put one moving average on their charts.  Sometimes they use two, three, or even more moving averages with different time periods.  The reason that they do this is that a shorter-period moving average is more responsive to price changes than a longer-period moving average is.  By comparing the two you can identify changes in short vs. long-term trends more quickly and trade accordingly.  When one moving average crosses another moving average, this is known as a crossover .  Let’s see some examples of this in action:

As you can see the 10-day moving average crossed the 20-day moving average to the downside on the 1 st of May.  If you had used this as your sell signal, you would have stayed in the stock the entire way up and sold 10% off of the peak, which amounts to a really good profit.  Getting in and getting out at the right time is the key to making real returns.

The importance of longer-term moving averages

You will often hear of the 200 day moving average talked about on business television.  The reason that this is so important goes back to our earlier discussion of market psychology: everyone is looking at it.  Guaranteed the big boys, like hedge funds with hundreds of billions of dollars of assets under management, are looking at it very closely.  The 200 day moving average often acts as either support or resistance for this reason.  Let’s see an example:

As you can see once the stock price got above the 200-day moving average in 2003 it didn’t really look back until 2008.  There were a number of times that the 200-day moving average acted as support in 2005 and 2006, with the stock bouncing off of support and continuing its movement higher.  Once it dropped below the 200-day moving average, it fell nearly 50% before bottoming out and turning upwards once again.  The stock then moved up above the 200-day in 2009 and is still above it today.  It did drop below the 200-day moving average in 2011.  Should this have been a sell signal?  What can we learn from this?

Adding in the 50-day moving average, we can see that the stock did drop below the 50-day moving average in July of 2011.  Had an investor sold immediately after the stock dropped below the 50-day moving average and bought again once the stock price climbed above the 50-day moving average one month later, the result would have been positive in terms of selling higher and buying lower.  In other scenarios this could have possibly led to a false sell signal.  For example if the investor had waited until the stock price had moved under the 50-day moving average by 10% or until the stock price had stayed under the 50-day moving average for 3 days, the net result would have been selling at a lower price and buying back in again at a higher price, which is the last thing you want to do.  One way that you can filter out false signals on long-term trends is to look for a cross-over in the long-term moving averages, which signals a change in long-term trend.

Bullish 50-Day / 200-Day Moving Average Crossover

Using the same chart, we can see that the 50-day moving average crossed the 200-day moving average to the upside in the summer of 2009.  This is the buy signal the pros would be looking for and going by a 50-day/200-day crossover, no sell signal has been given yet on this stock.

Bearish 50-Day / 200-Day Moving Average Crossover

Next we will go back in time and look at the bearish 50-day / 200-day moving average crossover, which happened most recently in 2008.  This is when the 50-day moving average crosses the 200-day moving average to the downside, signalling a downward long-term trend.  This would have given an investor a valid sell signal at $23, avoiding huge losses as the stock price fell all the way down to $13 at the bottom before climbing back up.

If an investor had sold at $23 and waited for the 50-day moving average to cross the 200-day to the upside, the re-purchase would have been at just over $16.  Had the investor held the stock until today, that $23 dollar stock is now worth $40 so it was still a great long-term investment in hindsight.  If the investor had sold at $23 and re-purchased at $16, rather than being up 74% (from $23 to $40) that investor would have been up 150% (from $16 to $40).  Paying attention to what the moving averages are telling you about long-term trends makes a huge difference in what returns you are going to see as an investor.  All of the pros are looking at this, and in general these are the moving average periods the people with big money are looking at:

Generally Accepted Important Moving Average Periods:

There is no right or wrong time period of moving averages to use.  Keep in mind that stock prices move in part due to the psychology of the market so even if certain moving averages aren’t important to you, they are important to other market participants.

You may find success using your own set of moving averages that differs slightly from what everyone else is using, say the 14 day and the 25 day, for example.  There is no magic answer that works in all cases.  Just keep in mind that it pays to pay attention to what other people are paying attention to.  If you can anticipate what the big money is going to do and act just before they do, you can earn a very good living trading stocks.

Now that you have a basic understanding of moving averages, we’ll move onto more advanced indicators and oscillators.