Anyone who has dabbled with charts would agree that one of the easiest tools available in technical analysis is the moving average. It gives buy and sell signals at the apt juncture that can be used by traders and investors alike to take or pare positions.
Let us start by defining what a moving average is. As we all know, an average is the middle value for a set of data. Since the value of the moving average line is calculated afresh for a pre-determined period with the latest data, the average "moves" over time. The moving average line helps in smoothing the data and pointing towards the underlying trend in the chart.
There are numerous types of moving averages. The more popular methods are the simple moving average and exponential moving averages (or exponential weighted moving averages). To construct the exponential moving average, the latest data is multiplied by an exponential percentage thus giving greater weight to the most recent data. Other ways in which moving averages can be constructed are by assigning weights governed by the volume or volatility over the time range.
The oft-used moving averages are the 10-day moving average, the 21-day moving average, the 50-day moving average and the 200-day moving average. Buy signals are generated when the stock price crosses above the moving average from below after a down trend, whereas the stock price falling below the moving average from the top after an uptrend will be a sell signal.
Many analysts use multiple moving averages and use the cross-over of these averages to generate or to confirm buy and sell signals. Moving averages work well in trending stocks. But they are difficult to implement when the stock is moving sideways or not trending. So, before attempting to incorporate the moving averages the traders should first identify the stocks that show some trending characteristics.
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