Moving averages

Celticheart Investor

A beginner's guide to trading and investing

Moving averages are not in fact a tool as such but just a smoothing out of the average share price activity to form a trend following indicator. 

They do not predict price direction as they are based on past share price so are, by definition, tracking what has already happened. Despite this delay, moving averages help smooth price action and filter out the noise. 

They also form the building blocks for many other technical indicators, such as the Bollinger bands we have already examined (the middle BB is also the EMA 20 line) and MACD (moving average convergence/divergence) which we will be looking at later on. 

The two most common types of moving averages are the Simple Moving Average (SMA) and the Exponential Moving Average (EMA). These moving averages can be used to identify the direction of a trend and are useful in helping to define potential support and resistance levels. It should be noted 
that it is not possible to create an EMA with out starting with an SMA.

Moving averages can be calculated over any given periods but generally 20 day and 50 day increments are used by most chartists. It is how the two periods interact that is most informative for share traders and investors alike.

Although not a strong enough indicator on its own, when the EMA 20 crosses above the EMA 50 it often signals a buy but when the EMA 20 crosses below the EMA 50 this signals a possible sell. Again I would stress that this applies in the main to traders rather than investors as often the fluctuations we are talking about are too small to consider a buy or sell unless you are trading in high volumes.

For greater accuracy in your judgements use the EMA 20/50 signals in conjunction with some of the candlestick patterns we have already covered.

I wont even begin to try and explain the formulas used to calculate the moving averages (both SMA and EMA) as, to be honest, for most small investors, what the moving averages tell us is far more important than how they were calculated. If you do want to take a more in-depth look at how they are created check out the link below:

http://stockcharts.com/school/doku.php?id=chart_school:technical_indicators:moving_averages

Next time: The MACD

A cautionary note, trading and investing in shares carries a level of risk, these blogs are only meant as a basic guideline to investing and trading, always do your own research and base your decisions on what you can afford to lose. This blog is not intended to provide financial advice as I am not qualified to do so, it is simply designed to provide information about how the markets work that might be of some help to private investors like myself.