Trading 101; How to use Average to Trade Stocks

When it comes to stock price data, a Moving Average (MA) helps to filter out all the noise, so a trader doesn’t have to stress about the fluctuations in the share market for a period of time. It shows the direction in which a stock price is moving by creating a frequently updated average price. A Moving Average can be modified to cover a specific time period and is suitable for both long-term and short-term trading. There are three main types of MA’s, namely; Simple, Exponential, and Linear Moving Average. Keep reading to find out how to use a moving average to trade stocks.

Types of Moving Average and their uses

Simple Moving Average (SMA)

The simple moving average, which is sometimes known as the arithmetic moving average, is the most common amongst traders. It is quite straightforward and used as an indicator by traders for when to enter or exit a market. An SMA can be calculated by taking the sum of all the previous closing prices of stocks over a time period (number of trading days) and dividing it by the total number of trading days.

Exponential Moving Average (EMA)

This is a little bit more complex. The exponential moving average adds more weight to the most recent prices and tends to react much faster to the changes in the price than the simple moving average. Calculating EMA’s can be complicated, so most charting software tends to do the calculation for you.

The major difference between simple moving average and the exponential moving average is the speed and sensitivity they place on price changes. EMA’s tend to react faster to changes in price trends than SMA’s.

Now that you have an idea of what a Moving Average is, it begs the question, how can you use them to buy stocks?  Below is how to use a moving average to trade stocks

This is quite simple; here are a few things to consider when using a moving average.

Moving Average Length and Time

This is the time frame you choose for a moving average, and it can influence its effectiveness. The most used MA lengths are 10, 20, 50, and 100 applied over a chart time which can range anywhere from a minute to several days. Depending on what kind of trader you are, MA length may vary. For a short-term trader, for example, a moving average with a short time frame is more suitable because it monitors price trends more closely and produces less look-back period. For a long-term trader, however, a moving average with a longer time frame may be more beneficial.

Moving Average Crossovers

A crossover signals when a price crosses above or below a moving average. It signifies a potential change in trend. One of the best ways to use this strategy is by using two MA’s on one chart (a long-term moving average and a short-term moving average). When the short-term moving average crosses above the long-term MA, it signifies an upward shift of the trend and is a signal to buy (this is called a golden cross). But, when the short-term moving average crosses below the long-term moving average, it signals a downward shift of the trend, and this is a good time to sell (this is known as a death cross).

Are there cons to using a moving average for stock trade?

While a Moving Average is useful in indicating trends in a stock market, there are some cons to using them. They depend on previous price data only and do not account for changes that may influence a security’s future performance, like changes in product demands, changing management of industries, and the emergence of new competitors.

In Conclusion

Moving Averages are useful tools that not only help in filtering out noise and fluctuations in price data but smooth it out to create a flowing trend. However, it is vital that, as a trader, you are fully knowledgeable on how to use them. So, before you make use of a moving average to trade stocks, make sure to identify and analyze the strength in each moving average at a specific time and for a specific stock. By doing this, it is easier to spot the momentum and trend that can earn you a profit.