Here is a look at just such an example. This is my favorite moving average, the 20 period moving average. I say period because depending on the time frame of the chart you are looking at, the moving average will adjust, averaging the last 20 bars of data, whether that's daily, weekly, or any other time frame.
This happens to be the daily view we are looking at, so this moving average is the 20 Day moving average. You can see how as price oscillates between the upper and lower range, the moving average will adjust to the trend direction and either move up or down as well. I like the 20 average because it is a long enough period to generally catch large intermediate term moves and short enough to get you out of too much trouble should prices go south.
An issue with moving averages however is that they are lagging indicators; they can only tell you what price has done, not what it will do next. So what that creates are slightly slower signals because they are reacting to the average price of that last 20 bars. It will never get you in at the exact bottom or out at the exact top, but it will catch or avoid the majority of a move.
Moving Average Slope
The first thing I look for with a moving average is whether it is moving up or down. The direction of the moving average will give you the general idea of the average trend over the given time period. Its a quick and dirty way to analyze a trend quickly and accurately. Ideally when prices are moving higher, the moving average will be as well and vice versa. Remember, it is important to always be aligned with the dominant trend, so being able to spot the trend quickly gives us an easy way to make sure we are trading in the right direction.
Here we can see a 2 year chart for Ross Stores; this is a daily bar chart and 20 day moving average. As price is rising in early 2012, 20 day moving average (20 DMA) is rising along with price as well, confirming that we are in an intermediate uptrend. When price begins to roll over in September 2012, you can see that the moving average is rolling over as well, confirming the intermediate term trend change. It wasn't until January of 2013 that the 20 DMA turned upward signaling a bottom for price was likely made; since that larger trend change, price has generally been higher.
A moving average by itself is not an investment strategy, but it can be used in tandem with other signals to confirm or dis-confirm trend change. One way that you can generate another signal trigger is to add a second moving average to your chart.
Bullish/Bearish Crosses
When using two moving averages simultaneously, a buy/sell signal is generated by the two lines crossing each other. A common moving average pair I use is the 20 and 50 period moving averages. So we are looking at a 20 bar average and a 50 bar average. The 20 bar average is going to be more responsive to shorter term movements than the longer average. What that does is help identify yet another way to signal a trend shift. When both the longer term and shorter term trends begin to move in the same direction, you can be more confident that trend is reliable. When the shorter of the two moving averages crosses the longer average a signal is generated saying that the short term price movement is signaling a shift of momentum from one direction to the other. Lets see how it looks in actual practice.
Here is an example of how you would use a two moving average strategy. At the most basic level, you would simply sell when the 20 DMA crosses below the 50 DMA. This signals that the short term trend is shifting and the longer term trend may be in jeopardy. And you would buy when the shorter term average crosses above the longer one. While not perfect in terms of exact tops and bottoms, this simple strategy got you out of the way when most of the damage was done and got you back in when things began to turn more positive.
A simple strategy I use for generating buy and sell signals is I will look to buy a stock that is above a rising 20 period moving average and look to sell a stock that is below a falling 20 period average. Typically I will use the weekly chart for core position entry/exit signals using the 20 week moving average. Once I have an established position that is trading above its rising 20 WMA I will turn to the shorter term 20 day average as a signal generator to identify short term opportunities to trade around my core holding. Basically when a stock is above its rising 20 period moving average I want to be long the stock (there are obviously other things I look at as well, but this is on of the top things I look for), and I want to look to sell a stock trading below a declining 20 period average.
Depending on the time frame I am looking at will determine whether I am getting a long term signal or a short term. The nice thing about moving averages is that they can be used on any time frame for trading. I do feel they have more consistency on a longer term chart, but that is also the case with most signals; longer term trends and patterns tend to be more reliable than shorter. The use of moving averages is simple and a quick way to identify a trend or trend change. I highly recommend integrating them into your signal generation plans for both buying and selling, at the very least they will offer additional confirmation of your trade.
Follow and respect the trend, your account balance will thank you for it.
I thought I would leave my first comment. I don’t know what to say except that I have enjoyed reading.
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