It’s amazing how many things in our lives we use–and benefit from–and have no idea how they work. For example, we know there are spark plugs under the hood of a car. Do most of us know how they work within the car’s engine to move me up the street? No clue.
Similarly, many of us who use price charts plotted with moving averages to track our stocks may not think about the actual construction of the moving average indicator—nor do we want to. After all, few things are as mind-boggling as chart indicator calculations.
However, if we have a deeper understanding of moving average construction, that knowledge will lead us to possible higher profits.
How to Support Decisions with Moving Averages
We say “higher profits” because moving averages are terrific decision-support tools. Used appropriately, we can combine the perspective they offer with price, volume and additional indicators to indicate buying opportunities, plan risk management, and determine exit strategies.
A moving average is a single-line indicator we plot on our price charts to give us a running average of price over a pre-determined time period. If the price of our stock, exchange traded fund, or other asset is trading above the moving average line, then we know that price is currently stronger than the assigned average. Should price be trading beneath the moving average line, then it is currently weaker than the assigned average price.
Want to plot a 50-day moving average for Whizzy Widgets? Write down Whizzy’s closing prices for the last 50 trading days. Add them together. Divide the sum by 50. Get out your pencil and put a dot on Whizzy’s price chart on today’s date.
Tomorrow, when Whizzy closes for the day, add that price to your list of closing prices. Then remove the earliest price from the list. Once again, total your updated list of (50) prices. Divide the sum by 50. Mark another dot on Whizzy’s price chart at tomorrow’s date. Now, draw a line connecting the two dots. Voila! You’ve constructed a moving average.
20-50-200 Day Moving Averages
On a daily chart, we often plot 20-day moving averages because there are 20-21 trading days in a month. If our stock’s price trades above the 20-day line, we know it is stronger than the most recent 20 days of closing prices.
We may also plot a 50-day moving average because that is an average tracked by many institutions. Institutional traders and investors are the big money folks who move markets. So, if they watch the 50-day moving average, then we are wise to watch the 50-day moving average. (The institutions generally prefer stocks trading above the 50-day line.)
The slow and lumbering 200-day moving average is another well-watched guideline. Since there are 240-250 trading days in the year, if our stock is trading above the 200-day line, and the 200-day line is rising, then our stock is relatively “healthy.” Should the stock fall below that line, especially for more than a week, it may be feeling feeble.
On this daily chart of the Walt Disney Co. (DIS), we can see that for much of the year, Disney has trended higher above its rising 20-day (red), 50-day (green), and 200-day moving averages (black)—an ideal scenario for investors.
Walt Disney Co. (DIS) Daily Chart
Chart courtesy RealTick
When we captured this chart, Disney stood just atop its 50-day moving average. If Disney can use this line for support–and traction–then it should be able to continue its uptrend. If the media giant slips below the 50-day moving average then short-term investors may take profits. Others may keep an eye on the 200-day MA for longer-term support and take gains if Disney falls below that line.
Knowing how moving averages are constructed and how they work on our price charts can help us become more successful traders and investors.
This article was originally submitted by Toni Turner. Toni is President of Trendstar Trading Group, LLC and an accomplished technical analyst as well as a popular educator and sought-after speaker in the financial arena. She is the author of the bestselling books: A Beginner’s Guide to Day Trading Online, 2nd Ed., A Beginner’s Guide to Short-term Trading, 2nd Ed.,Short-Term Trading in the New Stock Market, and Invest to Win: Earn & Keep Profits in Bull and Bear Markets with the GainsMaster Approach, co-authored with Gordon Scott CMT. Her books have been translated into five languages and used as textbooks in college personal finance classes.