A moving average (MA) is a simple yet effective technical indicator that shows you the average price of a stock during a specific period. That period could be 10 days, 15 minutes, or 40 weeks. On the price chart, the moving averages appear in the form of a smooth line representing the average price. Traders refer to the moving average to gauge the stock’s trend. Furthermore, they can use that data to make informed buying and selling decisions. When it comes to buying stocks using a moving average, traders are primarily looking for crossovers. Some traders even make purchasing decisions based on moving averages that are strong supports. Moving average strategies can be adjusted to different timeframes, making them suitable for long-term and short-term traders. Let’s expand on the key aspects that you must be aware of before using the MA to buy stocks.
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Defining Moving Averages
Moving averages are statistical calculations used in finance and investing to analyse trends over a specific period of time. They smooth out fluctuations in data by creating a constantly updated average price. This helps traders and investors identify the direction of a trend, filter out noise, and make more informed decisions based on historical price movements. Commonly used in stock trading, moving averages come in various forms, such as simple moving averages (SMA) and exponential moving averages (EMA), providing insights into potential buy or sell signals.
Importance of Moving Averages
- No strict rule mandates the use of moving averages in a trading setup, but they prove beneficial in minimising market noise.
- Moving averages offer a quick indication of the price trend, aiding traders in decision-making.
- An upward-angled moving average with the price trading above indicates an uptrend in the stock.
- Conversely, a downward-angled moving average with the price below signifies a downtrend.
- Frequent fluctuations above and below the moving average suggest a sideways trend in the stock.
- Successful trading often involves aligning actions with the prevailing trend in the market.
- Utilising moving averages enables traders to identify trends, assisting in making informed decisions to buy in uptrends and sell or short in downtrends.
Method of Buying Stocks Using Moving Averages
To witness significant stock growth, such as doubling or tripling in value, an uptrend is crucial. Investing in stocks on an upward trajectory is preferred, although not all uptrends guarantee substantial gains. Recognising the risk of trend reversals, savvy technical analysts avoid random entry points during uptrends. Instead, they rely on indicators like moving averages to identify opportune moments for stock purchases, aiming to steer clear of acquiring stocks just before a potential reversal. Among the favoured strategies, two prominent approaches include:
- Buy the stock at the crossover
- Buy the stock at the moving average support
Crossover Strategies
- The initial strategy involving moving averages is the price crossover. Employing an MA of any duration is suitable for this approach, where the stock is purchased when its price surpasses the MA line.
- The second strategy entails using two distinct moving averages with varying lengths, such as the 50-day and 200-day or the 10-week and 40-week moving averages. In this scenario, a buy signal, known as the golden cross, occurs when the shorter-term MA intersects above the longer-term moving average.
- Both the price and golden crossover strategies indicate a potential uptrend. Therefore, acquiring a stock following an MA crossover enables investors to enter at the onset of its potential upward trajectory.
Buying at the Support
In the event of missing the opportunity to purchase a stock at the onset of an uptrend, it doesn’t necessarily constitute a missed chance. Uptrending stocks typically present traders with multiple opportunities to build positions. One such opportunity arises at the moving average (MA) support.
A support zone essentially serves as a demand area, attracting numerous buyers eager to acquire the stock near its support level. When the stock price trends downward, it often rebounds upon reaching a support zone, with MA lines proving to be particularly robust support zones.
In an uptrend, the stock consistently trades above the MA line. Despite the overall upward direction, fluctuations occur. During these fluctuations, selling pressure might lead to temporary declines in stock prices. However, these downturns often find a halt near a strong support zone, including the MA line. Traders anticipate a price rebound and strategically buy at such support levels.
Drawbacks of Moving Averages
- Lagging Indicator: One of the biggest disadvantages of using the moving average to buy stocks is its lagging nature. Since the MA is calculated based on historical data—past closing prices—the signals are not precise enough. Often, at the time of the price crossover or the golden crossover, the price is already in an uptrend. Many traders complain that it fails to give them the best entry point; they only credit it for confirming the trend.
- False Signals: False signals represent another significant drawback, echoing the age-old adage that past price patterns in the stock market do not guarantee identical future patterns. The fact that a stock in an uptrend finds support on the moving average (MA) multiple times before continuing its upward trajectory does not imply a perpetual recurrence of such behaviour.
Support eventually breaks; however, before breaking, it may appear that the stock is taking support and is getting ready to bounce back. So traders buy the stock at the MA support or only for it to breach the MA support and start a downward trend. Likewise, there can be false crossovers. However, this issue of false signals is not exclusive to the moving average, and no technical indicator is foolproof.
Conclusion
The moving average helps you buy stocks in the direction of the trend. You can either buy stocks at an MA crossover or an MA support. However, due to the lagging nature of the indicator, many traders use the MA only as a trend confirmation indicator. Moreover, the MA is not foolproof, so always trade with a stop loss. For more precise entries and accurate results, consider using the MA in conjunction with other indicators. While moving averages are valuable for trend confirmation and entry points in stock trading, understanding what floating stocks are can further enhance your trading strategy.
