Moving Averages and the Trend

Moving Averages and the Trend

One of the key tenets of technical analysis is that “the trend is your friend”.  There are many tools in a Technical traders toolbox, and the Moving Average indicator is one of them.   It can be helpful in identifying trend reversals and continuances.  As long as you trade in the direction of the trend. 

Trend reversals may occur at any time.  One of the important skills a trader must possess is the ability to identify a reversal.  It is easy to exit a position too early by over anticipating a trend reversal, and just as easy to loose money by not exiting a trade quick enough.  

The use of a moving average is an excellent tool to help us identify trend reversals.  By plotting the proper moving average on a stock chart, we can watch for the stock’s price to penetrate the moving average to know that a reversal may be occur.

Moving averages come in two common forms: simple moving average (SMA) and exponential moving average (EMA) – also known as weighted moving average.   As a general rule of thumb, the exponential moving average weights more heavily the latest stock prices.

The chart to the right on First Solar shows a good example of how exponential moving averages can help us identify the trend.  Although the price of FSLR started moving down at the beginning of the year, the moving average indicator shows us that the overal trend is still moving up.  We know this because the 10 day exponential moving average line bounced off the 90 day moving average line and continued on its path upwards.   As long as the security is in trend, the moving average is relevant.

Sometimes a stock will consolidate (move sideways in a tight range), and in this case, the value of the moving average as a useful indicator diminishes. Consolidations are a bit more trickier to analyze and predict future price movement, and we will cover consolidations in another article in much more detail. 

Below are some of the key take aways to remember about moving averages:

• Moving averages are good trend indicators as long as the stock is not consolidating
• Exponential moving averages place more emphasis to the most recent data and are better indicators to use with high volatility stocks
• Simple moving averages are good trend indicators for low volatility stocks