Investing in the Stock Market is a complex business that requires a great understanding of what drives prices in any particular direction. That’s a discussion that is probably beyond the scope of what I propose to discuss.
Fortunately, there are a host of tools that can be used to assist a trader or investor in making better trading decisions. Fundamental and Technical analysis are the two broader categories for making trading decisions.
Fundalmental analysis deals with the company’s financial status, the market conditions surrounding the company’s product, in some cases environmental conditions that may affect a company’s product, suppliers, distributors, etc.
Technical analysis can include price charts, moving averages, support and resistance points, technical indicators derived from mathematical formulas such as momentum, stochastics, relative strenth, bollinger bands and many more.
This article will concentrate on moving averages; how they are determined and some ideas on how to apply them to price action.
Many chartists will use 10, 20 and 60 period moving averages, although there are many different views on what is the appropriate time period, selecting the appropriate time period for your particular stock or commodity may take some trial and error. Choose an average that provides support to reactions, especially the first reaction after a trend change.
If a market were to make a low, rally for 10 days, pull back 5 days to a higher low, then advance to a high that is higher than the first 10 day rally, the market has probably made a trend change. The length of the moving average should be one that offers support at the 5 day low. That is the price declines and touches the moving average and then begins to advance again, but doesn’t close below that average.
By definition prices and moving averages will move in the same direction, since the moving average is calculated by adding prices and dividing by your chosen period. But there are times when prices and moving averages diverge, giving you some insight to price direction and advance warning of a possible trend change.
When prices and the moving average are moving in the same direction large price movements are possible. But if the price moves too far away from the average one of two things has to happen. Either the average moves to the price or the price moves to the average. This is an important concept especially when price and average are moving in opposite directions.
If the price has had a large move that takes it far away from its moving average and they are moving in the same direction, it signals that prices are likely to slow and possibly reverse.
If the price has crossed its moving average and is now moving in the opposite direction, it can be said that the moving average is providing support (or resistance, depending on whether the price is advancing or declining) for further declines because it takes some time for the moving average to change direction and the average will move to the price or the price will move to the average. Generally, the price will move back to the average, create a series of price points below the average which will in turn cause the average to begin to decline.
When moving averages are flat it becomes possible for the price to move in either direction without tests of the moving average because the price movements will change the direction of the average quickly. So if the price is above the average and the average is flat, a price movement that crosses and moves below the average can continue in that direction for a while, but beware of head fakes, movements in one direction that reverse and head strongly in the other direction. This type of price action is usually strong and should be respected.