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> Technical Guide >
Moving averages |
Moving Averages
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Moving averages are among the most simple technical
indicators available. They are used to smooth the
price pattern of the stock, and provide an easy-to-see
indication whether the stock is currently trending
(moving up or down) or in a trading range (moving
sideways).
As the name implies, moving averages are based on
the averages of the stock's price (most commonly
its closing price).
A 20-day average will take the average of the stock's
closing price for the 20 most recent trading days.
The next day, the new day's stock price will be
added to the average, and the oldest price of the
previous 20 days will be taken out. This will create
a slowly-moving trend of the stock's price, in this
case a 20-day moving average, as seen in the chart
below.
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Click
here to view a larger updated version of the chart
at Stockcharts.com
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As
seen above, the actual price pattern of the stock
is very volatile, with a single day's price changing
by over $3. However, once we apply a 20-day indicator
to it, the pattern is smoothed, and we can see a
trend develop. As can be seen in early February,
even though the stock's price jumped more than $5,
the moving average did not change much, since it
took into account the last 20 days worth of data,
and smoothed the trendline.
For example, in mid February, just looking at the
stock's price pattern, it seemed that the stock
had stopped its upwards trend and was beginning
to go down. However, the moving averages indicated
that the stock was still in a strong uptrend which
would continue till early March. Heeding the moving
averages would have kept investors in the stock
during the rally in late February.
Likewise, the spike in the stock price in late May
and early June might have tempted investors to buy
into the stock again. However, the moving averages
told a different story. The moving average was flat
and indicated that an uptrend had not developed.
True enough, the stock started trading downwards
from early June right into July.
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Moving
averages are one of the most simple technical
indicators. It is based on the average of
a stock's closing price. It is used to
smooth the price pattern and show
whether the stock is trending upwards or
downwards.
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What
we covered above are called Simple Moving Averages,
or just Moving Averages. Another form of averaging
is known as Exponential Moving Averages or EMA for
short .
In simple moving averages, say a 20-Day moving average,
each of the 20 days' prices have equal weight in
calculating the average. However, in exponential
moving averages, the most recent prices have more
weight than the earliest ones.
As such, during a surprise rally, the exponential
moving average will respond faster and start to
trend upwards earlier. Take the chart below for
example. The simple moving average is marked in
blue, and the exponential moving average is marked
in red.
In late May, there was a sudden surge in RYL's stock
price. The exponential moving average, being more
sensitive, reacted quickly and started trending
upwards. On the other hand, the simple moving average
still took into account the previous down days,
and did not even register an upward trend till the
rally was almost over!
|
Click
here to view a larger updated version of the chart
at Stockcharts.com
|
So
which type of moving average is better?
Both have their own merit. The simple moving average
is less prone to whipsaws and false alarms, and
will only indicate trends when the price pattern
is more pronounced, while the exponential moving
average might register false alarms.
On the other hand, exponential moving averages are
more sensitive to sudden price changes and are able
to react faster. Since we are dealing with option
trading, we would tend to follow the exponential
moving averages, since their sensitivity and quick
movement are ideal for the short-term and volatile
nature of option trading.
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Exponential
Moving Averages give more weight to the
most recent data, and are therefore
more sensitive and can react
better to sudden price changes.
This makes them more suitable for option
trading.
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So, how
do we use moving averages?
As has beem mentioned, both simple and exponential
moving averages are primarily meant to indicate
whether the stock is in an uptrend, downtrend or
sideways trading range. This can help prevent investors
from buying into a stock that is stuck in a trading
range or starting to trend downwards.
Another common way of using both simple and exponential
moving averages is by noticing when the stock price
crosses above or below the moving average. This
shows that the trend (either up or down) has reversed,
and a new trend is developing.
Looking at the RYL chart above, the stock price
crossed upwards from below the exponential moving
average in late Februrary and late May, indicating
that investors are starting to buy the stock and
the trend is moving upwards. These would be good
times to buy call options
or any bullish option
strategy on the stock.
Conversely, at the end of March and early July,
the stock price crossed below the exponential moving
average, indicating that it was time to implement
bearish option strategies.
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When the stock
price crosses above the moving
average from below, it is time for bullish
strategies. When the price crosses
below the moving average from above, it
is time for bearish strategies.
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However,
it can be seen that the stock price crossed the
exponential moving average many times in those 6
months, creating a lot of false alarms. Heeding
every crossover would have been a very painful and
costly experience.
The reason for that is that a 20-Day exponential
moving average is probably too sensitive and erratic.
The moving average can be modified to accomodate
different periods or date ranges. For example, the
chart below presents both the 20-Day (in blue) and
50-Day exponential moving averages for CAT.
|
Click
here to view a larger updated version of the chart
at Stockcharts.com
|
As
can be seen, the 50-Day exponential moving average
(in red) is much smoother than the 20-Day, and therefore
can indicate trends better. In addition, the stock
price crosses it less often, producing less false
signals.
However, by the time the stock price crosses the
50-Day exponential moving average, the rally or
crash is almost over. In other words, the longer
the period being averaged, the less sensitive it
is, and the slower it is to react.
So what period moving averages should we choose?
This depends on the individual's risk profile and
investment strategies. Someone with a low risk profile
and long-term strategies might choose slower moving
averages, while someone willing to risk more might
go for faster moving averages. The most common ones
are 20-Day, 50-Day and 200-Day simple and exponential
moving averages; for short-term to long-term strategies,
in that order.
Since most option strategies are volatile and short-term
in nature, shorter moving averages (though more
risky with more false alarms) are needed to "catch
the wave". Some options investors compromise
by using a slightly slower moving average such as
the 24-Day and 30-Day averages.
Please be reminded that this indicator should not
be used on its own, but rather with one or two additional
indicators, in order to confirm any signals.
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Different periods
can be used for moving averages. The longer
the period, the more confirmed
the trend, but the less sensitive
it is to sudden price movements.
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