What makes a technical indicator popular? Usefulness or usability? It is fair to say that usability begets usefulness and not the other way round. An indicator successful in giving brilliant insights, will fail to become popular, if it is too difficult to play around, i.e. ease of plotting or calculating, tracking, as well as making sense of it. By that standard, moving average sits comfortably at the top of the list of popular indicators.
What is a moving average, and what does it do?
Any attempt to take a view on the stock price, starts with comparing it with its historical price. When you take an average of prices in a given period, what you get is a figure that has smoothened out the fluctuations. But more importantly, it tells us the point of anchor for that particular period, and how far or close the present price is with respect to that anchor. So far so good. Now, price is not a static event. Hence, for an average to make sense for a moving price, we allow a new price to fit in, while shedding the oldest price of the particular period, and this for you is the moving average. For example, let us assume that the prices of a stock X are 51,53,52,54 and 55 for days 1, 2, 3, 4 and 5 respectively. At the end of day 5, the average is 53, which is calculated by dividing the sum of figures by 5, the number of days. This can also be called the 5 day average calculated at the end of the fifth day. Let us say, on the sixth day, the price is 56. What would be the 5-day moving average, calculated on the 6th day? It is calculated by letting go of the price of the 1st day, and including the 6th day’s price, thus keeping the analysis period to 5. Hence the average becomes (53+52+54+55+56) / 5, which is 54.
This discussion on calculation is not much relevant today on a day to day basis for normal users, as the moving averages of various periodicities are available for being plotted in all technical charting applications, without much ado. Algo traders or quantitative analysts do make use of the concepts, which we will get to later. It should also be mentioned that moving averages (MAs) are of two types mainly, Simple Moving Averages (SMA) and Exponential Moving Averages (EMA), but for the sake of discussion here, we are going to generalise and refer to them as MAs rather than making any distinction. Before leaving the discussion on the type of moving averages, it is imperative to note that EMAs move faster than an SMA would. Hence, depending on how quickly the investor would want his MA to show a change, or for how long his trading idea is expected to be in play, he/she could choose a convenient type of MA.
Working with moving averages
At an elementary level, and without complicating any further, while also keeping the analysis useful, the most basic aspect of a MA play that needs to be remembered, is the choice of periodicity, i.e. whether you are tracking 5, 10, 15 day MAs or a 60, 100, 200 day MAs or other custom periods. The choice of an appropriate MA is the bedrock of MA based analysis. This is not at all difficult to understand or master though, just needs some time. The bigger the number, like 60 and above, the MAs move slower than the shorter MAs and are mainly used for long term plays. The opposite is true for the shorter term periodicities, say a 5 day MA, or MAs for periodicities less than 50 and are hence used for short term plays like a few days, or even intraday.
Moving Averages and other technical indicators.
Bollinger Bands: Those familiar with this indicator will be used to seeing an envelope above and below prices that act as support resistances. These envelopes are usually drawn at a distance of 2 standard deviation of a 20-day moving average, thus putting MA at the centre of a very easy and popular technical indicator.
MACD: This is another popular indicator seen in most of the investors’ charts. But did you know that this also uses MAs? As the name indicates, it is the analysis of convergence as well as a divergence from a few MAs. MACD is actually calculated by subtracting the 26 period EMA from 12 periods EMA, and then you make a signal line by taking the 9 day EMA of the MACD, and use the convergence or divergence of this signal as well as MACD lines for getting trading signals.
The 200 day MA signal: Now this is not an indicator as such, but a 200 day MA is widely recognized as the benchmark for determining whether a stock is in uptrend or downtrend, and such as act as crucial support as well for those making long term bets. Since this is a widely tracked level, a crossover of the same is an equally significant event. A Golden Cross happens for a stock, when the 200 day MA is crossed by its 50 day MA from below, hinting at a sustainable uptrend. Alternatively, a Death Cross happens for a stock, when the 200 day MA is crossed by its 50 day MA from above, hinting at the end of an uptrend, and potentially as the start of a downtrend or volatility.
Ending note: For all the popularity of moving averages, it is a known fact that it is a lagging indicator. This means that it does not foretell a signal, as much as it confirms an undergoing trend. Often, the best plays are confidence plays, rather than ones picking tops or bottoms. This is the charm of MAs, and also the reason why, trend traders live and die by moving averages.