Moving Averages

Although most of my topics are geared towards buy-and-hold readers, there are times when learning technical analysis can come in handy. Charters or technicians (both terms are often used) have an arsenal of weapons at hand, including indicators, moving averages, and volume. These patterns are often used by traders to determine enter and exit points and strategies to maximize returns and lower risk.

My friend Christian asked me to write a post about Fibonacci Bands and it got me thinking, maybe I should write about the basics of technical analysis for you guys. It's helped me make a lot of money over the past few years as well.

I won't immediately post about Fibonacci Bands because some of its foundation is built on basic technical analysis theories, so I will start with the most commonly-used pattern - moving averages.

There are two types of moving averages that I've seen: Simple Moving Averages (SMA) and Exponential Moving Averages (EMA).

When it comes to trading, I prefer using the SMA. As it name indicates, it is simple. The moving average takes the closing values of the past x days and takes the average, then plots it on a chart. You can also do this by hand if you really wanted as well. Most traders like to use 20 days, 50 days, and 200 days, and many websites allow for three moving averages to be plotted on a chart.

The chart below (www.bigcharts.com) of Google plots the SMA 20, 50, 200 and creates a line chart for each moving average coloured yellow, blue, and pink respectively. Ignore the red lines; those are Bollinger Bands, a future chapter.



Moving averages can be significant for traders. A moving average charting higher indicates a bullish trend and vice versa. This provides some direction on where the market or stock may be going in the short term.

A second reason moving averages are important is when they cross. When the moving average of a shorter-term (20 for example) moves above the moving average of a longer-term (50), it indicates a bullish trend. This is known as a golden cross and the time to buy is now. When the moving average of the short-term goes below the long-term, it's a signal to sell. This is known as a death cross. The names are quite self-explanatory.

If we use the Google chart above, find a location where the yellow, blue, or pink lines cross. You can see that when the 20-day (yellow) dropped below the 50-day (blue) and 200-day (pink), it was followed by falling prices or stalled rises.

These signals carry more weight when attributed with above average volume. Volume represents the number of shares traded in a day and indicates conviction. Many times on television, you will hear them say, "very little volume" or "heavy volume." Take note of that because it can be very important when you want it to confirm with patterns.

On Monday May 10, I posted this article "Dead Cat Bounce in the Making" and wrote "Tomorrow is the third day, and if it does not trade and close above that level, expect another bad month of May." It is now Friday and the market has dropped again. It took a few days, but shorts are now making good money.

Although signals never work 100 per cent of the time, it is good to ease fears or calm excitement. Many traders do not use charts and as a result, emotions can get the best of them. Charts allow people to understand how a specific stock trades and if the recent drop in the price is nothing but noise over the long-term goal.

Good luck and if you want to try it, follow some big stocks in the next few weeks and see if it works. Let me know about your success.