Friday, February 10, 2012

February 10, 2012- Moving Averages Explained

Like I said in my post on My Indicators, if there is one thing to learn about technical analysis and the stock market, it is moving averages. They are easy to use, easy to understand, and give extremely clear buy and sell signals. There are many people who use only moving averages to trade, and they are mostly successful.

Before I show you examples of  using Moving Averages on Stocks, lets define the 3 main types, since there are many slightly different ones.
  • Simple Moving Average- The most common type, and the default on most charting programs. An SMA adds all of the closing prices of the stock during a period and divides it by the amount of days. 
  • Weighted Moving Average- Also Known as the Linear Moving Average, this gives larger weight to the most recent prices. For example, in a 10 day WMA, the oldest day would receive a weight of 1, 2nd oldest would be a 2, most recent would receive a 10, 2nd most recent would receive a 9.
                 Equation for 3-day WMA=  (3rd most recent*1) + (2nd most recent*2) + (Most Recent*3)
                                                                                        (1     +        2     +         3)            
  • Exponential Moving Average- A very effective indicator, the EMA is like the WMA except that it gives more weight to the most recent stock prices using an exponential scale. Chart School explains it perfectly, but here is their visual:

Now, I only use simple moving averages because I thing that they work the best for me, but all three MA's are great indicators. The examples I will show below are all Simple Moving Averages.


Chart: Ford - Daily
Range: June 1st, 2010 - October 1st, 2011
Moving Average: SMA 30-day

Using a 30-day MA, and ONLY a 30-day MA, The green arrows represent buy (cover buy) signals and the red arrows represent sell (sell short) signals. Using the moving average strategy on Ford obviously yields a successful return during this time period. The first Buy and Sell would have yielded 6.1% gain. The second Buy and Sell signal would have yielded a 42.4% gain. The Final Buy and Sell signal would have yielded a 1.9% gain.

Chart: General Electric - Daily
Range: June 1st, 2010 - March 22, 2011
Moving Average: 30 Day SMA

Same as Ford, using a 30 day SMA trading strategy, Buy signals are green arrows and Sell signals are red arrows. Averaging the 4 transactions, the AVERAGE GAIN during this time period would be 8.89%.

Chart: Chipotle - Daily
Range: August 6, 2010 - August 11, 2011
Moving Average: 50 Day SMA

As you can see, the 50 day SMA is a lot smoother and therefore there are less buy signals then the 30-day would yield. In this example, there are 4 Buy-Sell Signals. The Average gain on the 4 transactions is 17.62%

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