Among the most basic classes of technical metrics stock traders use to assess a stock are those that analyze moving averages. Moving averages come standard in many stock charts, so it’s critical for traders to understand exactly what they are and how to best use them as buy and sell signals.
Put simply, a moving average is a measure of a stock’s mean share price over a specified period of time. The “moving” part of the equation means that the average is calculated on a rolling basis.
For example, consider a stock that has a 50-day simple moving average value, which is calculated by averaging its price from day 1 to day 50 of a 50-day stretch. On the following day, day 51, its 50-day moving average will be calculated as the mean of its share prices from day 2 to day 51. The following day, it will be the mean of day 3 to day 52.
The “rolling” nature of moving averages makes them appear as a smooth line on a stock’s chart. The line fluctuates each day because the oldest price in its calculation is replaced by the most recent day’s price.
Simple moving averages weigh each day’s price equally when calculating the mean. Exponential moving averages, on the other hand, place greater weight on more recent prices and tend to be less smooth as a result.
Moving averages are a sign of momentum. They tell traders where a stock has been and where it could be going. A moving average with a positive slope indicates the stock has been in an uptrend. If a stock’s current price is above its moving average, it means the stock has bullish near-term momentum.
Longer-term moving averages incorporate more data points and tend to be smoother. Traders can also use these longer-term moving averages to get a clearer sense of a stock’s overall trend, especially if its short-term trading action has been extremely volatile.
Traders use moving averages as trading tools in a variety of different ways. Below are three common ways they are used.
Some traders use moving averages as potential support and resistance levels. Stocks in an uptrend often find support at major moving averages, such as the commonly used 50-day and 200-day simple moving averages. Traders often buy stocks in an uptrend as they approach their major moving averages from above and sell stocks in a downtrend as they approach their major moving averages from below.
Another way traders use moving averages is for mean reversion trading strategies. Since stocks tend to “hug” their major moving averages in the long-term, mean reversion traders will look for stocks that have broken out well above or below their moving averages and place trades that profit if and when they revert back to those lines in time.
Finally, traders often use moving average cross-overs as trading signals. When the 50-day simple moving average crosses above the 200-day simple moving average, it is a buy signal commonly referred to as the “golden cross.” When the 50-day moving average crosses below the 200-day moving average, it is a common sell signal referred to as the “death cross.”
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