These 3 charts help you understand how moving averages work
By Elliott Wave International
Moving averages are a popular tool for technical traders because they can "smooth" price fluctuations in any chart. Senior Analyst Jeffrey Kennedy gives a clear definition:
"A moving average is simply the average value of data over a specified time period, and it is used to figure out whether the price of a stock or commodity is trending up or down... one way to think of a moving average is that it's an automated trend line."
Moving averages are both easy to create and extraordinarily dynamic. You can choose which time frame to study as well as which data points to use (open, high, low, close or midpoint of a trading range).
The following excerpt is from our online course, How to Trade the Highest Probability Opportunities: Moving Averages.
Let's begin with the most commonly-used moving averages among market technicians: the 50- and 200-day simple moving averages. These two trend lines often serve as areas of resistance or support.
For example, the chart below shows the circled areas where the 200-period SMA provided resistance in an April-to-May upward move in the DJIA (top circle on the heavy black line), and the 50-period SMA provided support (lower circle on the blue line).
The 13-period SMA is a widely used simple moving average that works equally well in commodities, currencies, and stocks. In the sugar chart below, prices crossed the line (marked by the short, red vertical line), and that cross led to a substantial rally. This chart also shows a whipsaw in the market, which is circled:
Another popular moving average setting that many people work with is the 13- and the 26-period moving averages in tandem. The figure below shows a crossover system, using a 13-week and a 26-week simple moving average of the close on a 2004 stock chart of Johnson & Johnson. Obviously, the number 26 is two times 13:
During this four-year period, the range in this stock was a little over $20.00, which is not much price appreciation. This dual moving average system worked well in a relatively bad market by identifying a number of buyside and sellside trading opportunities.
Moving Averages aren't the only technical indicators that can alert you to market opportunities -- these three charts provide only a small example of how your trading skills can improve when you learn to identify technical indicators to support your chart analysis.
Moving averages are one of the most widely-used methods of technical analysis because they are simple to use, and they work. Learn how to apply them to your trading and investing with this free 10-page eBook from EWI's Jeffrey Kennedy.