Learn how to use one of the simplest and most effective technical stock trading indicators: Moving Averages.
One of the most effective and widely used technical trading indicators is the simple moving average. The choice of which intervals of time that should be selected for a moving average can vary greatly. For example many Swing Traders like to use the 10 day simple moving average and the 30 day moving average to determine entry points either on the long or the short side. Day traders may choose a shorter time frame to identify a short term trend they hope will produce quick profits.
Within the school of which moving averages to use, there are two that many professionals feel stand out among the moving average prospects. These two moving averages are the 50 day and 200 day moving averages. Instead of going into the significance of these two time frames lets look how they are used to make trading decisions and just recognize the pure fact that many professional and large fund managers (the market movers) watch these moving averages and make trading decisions based upon them. This should be motivation enough to learn how these technical indicators are used.
The first and most widely used usage of the 50 day and 200 day moving average is to emphasize the trend and smooth out price movements that can easily confuse an investor. The visual of a moving average that is pointing sharply upward or downward is very easy to interpret. It is often thought that a stock that has a price trading above its 50 day moving average and if the 50 day moving average is above the 200 day moving average, then the stock is healthy and should continue upward in the near future. The opposite is also true: if a stock is trading below its 50 day moving average and the moving average is below the 200 day moving average, the stock should go down in the future. These are the stocks many people avoid or look at as shorting opportunities.
The 50 day and 200 day moving averages are also used as support and resistance areas. If you look closely at any chart you should be able to see that these two moving average are like magnets that draw price to them and then reject that price sending it back in the direction that it originally came. A perfect example of this can be seen in the recent price action of the S&P Index. If you watch price in early April 2008 on the SPX you will observe that price breaks strongly through the 50 day moving average. By mid April price has been drawn back to the 50 day moving average and trades slightly below it before prices are pushed upward toward the 200 day moving average. Price is then drawn in a stair step fashion upward toward the 200 day moving average until mid-May where price finally hits the 200 day moving average but is rejected and tossed back down toward the 50 day moving average. Price then bounces off the 50 day moving average twice before making its fatal move below the 50 day moving average in early June never looking back until price plummets nearly 200 points below the 200 day moving average in mid-July. Buy and sell points can be easily found in this example both on the long and short side and truly displays how these moving averages can be used as support and resistance areas where trading decisions can be made.
The last use to be discussed is the 50 and 200 day moving average crossover. The concept is simple when the 50 day moving average of a stock crosses above the 200 day moving average it is considered a buy signal, if the 50 day moving average crosses below the 200 day moving average it is considered a sell signal. There are some traders who will buy the morning after the 50 day moving average crosses over the 200 day moving average and will hold that position until the morning after the 50 day moving average crosses back down below the 200 day moving average. This is a longer term strategy that will keep you in the market during rallies, even when price does the inevitable retrace but will get you out quickly if the correction becomes more serious. An investor does need to be careful of whipsaw markets, with this strategy, where price is moving sideways instead of in a defined trend. In this type of market unprofitable buy and sell signals can frequently be generated.
Whether used to give a visual display of the current trend of a stock or to use the 50 day and 200 day moving averages as a buy and sell indicator on crossovers or support and resistance areas, these two technical tools should be found in every traders toolbox.