Moving Averages Explained

Moving averages smooth out price data to reveal trends. They're among the most widely used technical indicators and form the foundation of many trading strategies. [DEFINITION] Moving Average (MA): A calculation that averages a stock's price over a specific number of periods, creating a smoothed line that shows the trend direction. ### Types of Moving Averages **Simple Moving Average (SMA):** Equal weight to all prices in the period. [FORMULA] SMA = (Sum of Closing Prices) ÷ Number of Periods [EXAMPLE] 5-day SMA with prices $10, $11, $12, $11, $13: SMA = ($10 + $11 + $12 + $11 + $13) ÷ 5 = $11.40 **Exponential Moving Average (EMA):** More weight to recent prices, reacts faster to changes. [TIP] EMAs respond more quickly to price changes, making them better for short-term trading. SMAs are smoother and better for identifying longer-term trends. ### Common Moving Average Periods | Period | Use Case | |--------|----------| | 10-day | Very short-term momentum | | 20-day | Short-term trend | | 50-day | Intermediate trend | | 100-day | Medium-term trend | | 200-day | Long-term trend | [KEY] The 50-day and 200-day moving averages are watched by virtually all institutional investors. They're self-fulfilling because so many traders act on them. ### Trading with Moving Averages **Price vs. MA signals:** - Price above MA = bullish - Price below MA = bearish - Price crossing above MA = buy signal - Price crossing below MA = sell signal **MA crossovers:** - Short MA crosses above long MA = "Golden Cross" (bullish) - Short MA crosses below long MA = "Death Cross" (bearish) [EXAMPLE] A "Golden Cross" occurs when the 50-day MA crosses above the 200-day MA. This signals the intermediate trend has turned bullish within a longer-term context. ### Moving Averages as Support/Resistance MAs often act as dynamic support and resistance: [EXAMPLE] Apple pulls back during an uptrend. Buyers step in at the 50-day MA multiple times. The MA becomes a reliable support level for swing traders. [WARNING] Moving averages are lagging indicators—they tell you what HAS happened, not what WILL happen. In choppy, sideways markets, MA signals generate many false signals. [EXERCISE] A stock's 20-day SMA is $50 and its 50-day SMA is $48. The stock currently trades at $52. What does this setup suggest? |ANSWER| Bullish setup: Price is above both MAs, and the shorter MA (20-day) is above the longer MA (50-day). This indicates upward momentum in both the short and intermediate term. [SCENARIO] You're watching a stock trading above its 200-day MA. It pulls back to test the MA three times over two months, bouncing each time. On the fourth test, it closes below the 200-day MA with heavy volume. This break of long-term support is a significant bearish signal—many institutions use this as a sell trigger.