How Moving Averages can help improve your investing decisions using worked examples

Watching the volatility of the major indices around the world over the past few trading sessions has been eventful to say the least. The panic set in, and the sell offs were exceptional. But how do you know when it’s safe to venture back into the market? One key (yet simple) chart indicator, which can be used to determine where stability lies, is the Moving Average. A Moving Average is an indicator that smooths out past prices. The most common form of Moving Average is a simple moving average, often referred to as “MA”. This is a lagging indicator, meaning it gives a view on past price performance, and is pretty straightforward to calculate.

The most common uses of Moving Averages are over 50-day, 100-day and 200-day time periods, referred to as 50MA, 100MA and 200MA. These provide investors with a short, medium and long-term view of how a price has performed over the relevant number of days. The Moving Average is most calculated by adding up the close prices at the end of each of each trading day over the preceding number of relevant trading days and then dividing that sum by the total number of days.

For example an investor wants to calculate an ultra short moving average, say 5MA. The stock the investor is looking at closes at the following prices over the preceding 5 days:

  • 11p on Day 1
  • 12p on Day 2
  • 13p on Day 3
  • 14p on Day 4
  • 15p on Day 5

By adding up the close prices for each day (11p, 12p, 13p, 14p & 15p) the total = 65. Dividing 65 by 5 (the MA’s time period) this = 13p. Therefor the 5MA for the example stock being looked at is 13p.

By using Moving Averages this can provide investors with useful information on current price trends and also provide possible warnings of a change in trend. For example if a stock trades above its 200MA it is widely accepted that the stock is in a bull market. The chances are it will continue to rise. If a stock is trading below its 200MA then it might be in a bear market and the chances are it will continue to trade lower.

When stock prices reach a long-standing moving average, this can often be a critical point for determining what might happen next.

In a bull market, if a price drops to a long-standing moving average and rallies positively off it then this is often a bullish indicator. Equally, if a price drops to a long-standing moving average and keeps dropping then this is often a bearish indicator, which might suggest a change in trend to a bear market. The same logic applies in reverse in a bear market. If a price rises to a long-standing moving average, reverses and drops again then this is often a bearish indicator. However, if a price rises to a long-standing moving average and keeps on rising then this could be a bullish indicator, suggesting a change in trend to a bull market.

Using Moving Averages in practice

When using moving averages, my first port of call is to view the daily chart over a long period of time to give plenty of historical context to recent prices moves. In bullish times moving averages lag current price action, and vice versa for bearish moves, so points where the price intersects a moving average are key indicators for changes in a trend.

Looking at the Dow Jones Industrial Average (DJI) chart and it is clear the 50MA gave weak support.  Once this initial support suspect had been broken, the price action accelerated lower, towards the 100MA.  In usual day to day trading previous highs and lows are respected as support and resistance, but with high volatility, the elevator will miss many floors out.  To put the brakes on a momentous move, strong and trusted support levels are called upon – and moving averages have proven themselves in this respect, time and time again. The 100MA proved to be support with a strong bounce on Monday, followed by confirmation on Tuesday. As I write, the Dow Jones is back above the 50MA at around 25,000.  A close above it would be very reassuring, implying this was a much-needed correction after a runaway period of bullishness in equities, as opposed to a continued crash.

Other indices showed similar movements. In reaction to the US market collapse, the Japanese Nikkei plummeted through its 50MA and 100MA. It didn’t quite touch its 200MA due to high demand at that level, but it got very close and a strong rebound ensued from there.

As you would expect, the S&P 500 chart print is very similar to the Dow Jones, with the 100MA also providing support. When moving averages on the daily charts are broken, all eyes move to the weekly moving averages.

The key daily MAs on the FTSE 100 have all been broken, but a look at the weekly chart reveals the weekly 100MA proved to be very strong support. In fact, it’s quite possible the FTSE 100 will end the week up which again will bode very well for a continuation of this rebound rally.

While this kind of correction strikes fear across the markets, it’s important to stay rational and calm. Corrections can be considered very useful events. They offer value investors the opportunity to buy stocks at a potential discount, and provide a good reminder to us all that the good times will not last forever.

There’s a big difference between a correction and a crash. ‘Bear market’ conditions require a much more sustained down trend to take hold. Although there is no definitive figure, it is broadly accepted that a downturn of 20% or more from a peak in multiple market indices over a 2-month period is considered a potential entry into a bear market. Of course, when this happens investors can find their portfolios significantly battered so it’s important to keep an eye on the early warning systems; Moving Averages being one of them.

Author: Stuart Langelaan

Leave a Reply

Your email address will not be published. Required fields are marked *