How to Use a Moving Average to Buy Stocks

The moving average (MA) is a simple technical analysis tool that smooths out price data by creating a constantly updated average price. The average is taken over a specific period of time, like 10 days, 20 minutes, 30 weeks, or any time period the trader chooses. There are advantages to using a moving average in your trading, as well as options on what type of moving average to use.

Moving average strategies are also popular and can be tailored to any time frame, suiting both long-term investors and short-term traders.

Why Use a Moving Average?

A moving average helps cut down the amount of noise on a price chart. Look at the direction of the moving average to get a basic idea of which way the price is moving. If it is angled up, the price is moving up (or was recently) overall; angled down, and the price is moving down overall; moving sideways, and the price is likely in a range.

A moving average can also act as support or resistance. In an uptrend, a 50-day, 100-day, or 200-day moving average may act as a support level, as shown in the figure below. This is because the average acts like a floor (support), so the price bounces up off of it. In a downtrend, a moving average may act as resistance; like a ceiling, the price hits the level and then starts to drop again.

Price won't always respect the moving average in this way. It may run through it slightly or stop and reverse before reaching it. 

As a general guideline, if the price is above a moving average, the trend is up. If the price is below a moving average, the trend is down. However, moving averages can have different lengths (discussed shortly), so one MA may indicate an uptrend while another MA indicates a downtrend.

Types of Moving Averages

A moving average can be calculated in different ways. A five-day simple moving average (SMA) adds up the five most recent daily closing prices and divides the figure by five to create a new average each day. Each average is connected to the next, creating the singular flowing line.

Another popular type of moving average is the exponential moving average (EMA). The calculation is more complex, as it applies more weighting to the most recent prices. If you plot a 50-day SMA and a 50-day EMA on the same chart, you'll notice that the EMA reacts more quickly to price changes than the SMA does, due to the additional weighting on recent price data.

Charting software and trading platforms do the calculations, so no manual math is required to use a moving average.

One type of MA isn't better than another. An EMA may work better in a stock or financial market for a time, and at other times, an SMA may work better. The time frame chosen for a moving average will also play a significant role in how effective it is (regardless of type).

Moving Average Length

Common moving average lengths are 10, 20, 50, 100, and 200. These lengths can be applied to any chart time frame (one minute, daily, weekly, etc.), depending on the trader's time horizon. The time frame or length you choose for a moving average, also called the "look back period," can play a big role in how effective it is.

An MA with a short time frame will react much quicker to price changes than an MA with a long look-back period. In the figure below, the 20-day moving average more closely tracks the actual price than the 100-day moving average does.

The 20-day may be of analytical benefit to a shorter-term trader since it follows the price more closely and, therefore, produces less lag than the longer-term moving average. A 100-day MA may be more beneficial to a longer-term trader.

Lag is the time it takes for a moving average to signal a potential reversal. Recall that, as a general guideline, when the price is above a moving average, the trend is considered up. So when the price drops below the moving average, it signals a potential reversal based on that MA. A 20-day moving average will provide many more reversal signals than a 100-day moving average.

A moving average can be any length: 15, 28, 89, etc. Adjusting the moving average so it provides more accurate signals on historical data may help create better future signals.

Trading Strategies: Crossovers

Crossovers are one of the main moving average strategies. The first type is a price crossover, which is when the price crosses above or below a moving average to signal a potential change in trend.

Another strategy is to apply two moving averages to a chart: one longer and one shorter. When the shorter-term MA crosses above the longer-term MA, it's considered a buy signal, as it indicates that the trend is up. This signal is known as a golden cross. Meanwhile, when the shorter-term MA crosses below the longer-term MA, it's considered a sell signal, as it indicates that the trend is moving down. This signal is known as a death cross.

Pros and Cons of Using Moving Averages

Pros of Using Moving Averages

Using moving averages in stock trading is a common strategy that offers clear insights and easy-to-follow signals. Some of the pros are as follows:

• Trend Identification: Moving averages help identify the direction of the market trend. By smoothing out price data over a specific period, they provide a clearer view of the overall direction, helping traders to make decisions aligned with the trend.
• Signal Generation: Traders often use the crossover of different moving averages as buy or sell signals.
• Support and Resistance Level Determination: Moving averages can act as dynamic support and resistance levels. Prices often bounce off these moving average lines, which can help traders identify potential entry and exit points.
• Simplicity and Efficiency: Moving averages are straightforward to use and interpret, making them accessible even to novice traders. Also, they can be easily incorporated into automated trading systems.
  

Cons of Using Moving Averages

Like all methods and approaches, there are disadvantages to them. The cons of using moving averages include:

• Lagging Indicator: Since moving averages are based on past prices, they inherently lag. During fast moving market conditions or at the onset of new trends, moving averages may signal the entry or exit too late, potentially reducing profits or increasing losses.
• False Signals: In sideways or choppy markets, moving averages can produce numerous false signals, leading to confusion and potential losses.
• Sensitivity to Time Period: The effectiveness of a moving average is significantly influenced by the chosen time period. Different periods may work well in some market conditions but poorly in others, and there is no one-size-fits-all period.
• Oversimplification: Relying solely on moving averages may oversimplify market analysis by ignoring other important factors like volume, market sentiment, as well as economic and financial indicators. A comprehensive approach typically yields better results.

The Bottom Line

To effectively use a moving average to buy stocks, it is essential to choose the right type and length of the moving average that aligns with your trading strategy. A common approach is to utilize crossover strategies, where a buy signal is generated when a shorter-term moving average crosses above a longer-term moving average, indicating a potential upward trend.

This method can be enhanced by confirming the trend with additional indicators such as volume or the MACD to ensure robustness and reduce false signals. Traders should adjust the sensitivity of the moving average based on the volatility and characteristics of the stock to tailor it to their specific needs. Indeed, by carefully managing risks with stop loss orders and continuously monitoring the market conditions for changes, traders can use moving averages as a powerful tool in their stock buying strategy.