Stocks can only go up, down, or sideways. Prices rise or fall, that is how investors make and lose money. In order to make this seemingly random mechanism systematic in some way, technical analysts do weird things with the price history of a stock. Moving averages are one type of the many weird modifications that technical analysts have produced.
In simple words, a moving average is the average of the last few days. In a 5 day moving average, we take the average of the stock price of the last five days. When the market opens tomorrow and a stock creates a new closing price, the 5-day moving average will include that value but ignore the value of the oldest day. This causes a change in the average. This is why a moving average is called a “moving” average because when plotted in a chart, the change in value causes it to move after every trading session!
Simple Moving Average (SMA)
A simple moving average is the simplest moving average. The example I gave earlier was of a 5 day Simple Moving Average. We gave equal priority to the value of the particular day and the value from 5 days back.
The most popular simple moving averages include the 10, 20, 50, 100, and 200. Traders often use the smaller, faster-moving averages as entry triggers and the longer, slower-moving averages as clear trend filters.
Exponential Moving Average (EMA)
Basically, the EMA is an average, but it puts more weight on recent prices than the prices long ago. An EMA is considered more sensitive and accurate than the normal average, the simple moving average (SMA).
The 12- and 26-day exponential moving averages (EMAs) are often the most quoted and analyzed short-term averages. The 12- and 26-day are used to create indicators like the moving average convergence divergence (MACD) and the percentage price oscillator (PPO).
Useful Rules to Determine the Trend Using Moving Averages
1) If a stock price is above the 5-day and 8-day SMA, begin evaluating the stock. Otherwise, proceed with caution.
2) If the 21-day SMA and 34-day EMA cross below the 50-day SMA, the stock is in an intermediate downtrend. Avoid the stock until both of them cross above the 50-day SMA.
3) If the stock price is below 50-day SMA, avoid the stock. The 50-day SMA is your support or resistance level.
4) The 50-day SMA should be above the 100-day EMA and 200-day SMA.
5) If the stock price is below the 100-day EMA and 200-day SMA, abandon the stock.
Moving average convergence divergence (MACD)
Let us say you take the average price of each day in the last year. And you also take the average price of each day in the last month. Now, if the average of 30 days is higher than the average of a year, what does it mean?
It means that the price, in general, was higher on most days of the last month than in the last year. Do you get it?
Now, if the price suddenly rises aggressively tomorrow, which of the average will show the most change? The monthly average, right? This is because the yearly average has more data and is less influenced by the change of a single day.
Now, if we plot the averages in each day, it will form a line on the chart. The line of the monthly average will fluctuate faster with the change in trend. Thus, in a chart, the monthly average line will seem to be responding faster to price fluctuation than the yearly average. In this case, the monthly line is called the fast line and the yearly line is the slow line.
The MACD uses this same simple principle to interpret any change in a trend.
The MACD is calculated by subtracting the 26-period Exponential Moving Average (EMA) from the 12-period EMA. Basically, the EMA is average, but it puts more weight on recent prices than the prices long ago. An EMA is considered more sensitive and accurate than the normal average, the simple moving average (SMA). The MACD is then plotted alongside the 9-day EMA line.
Let me translate that in English: The MACD uses one line obtained by subtracting the 26-day and 12-day EMA. This line is plotted alongside another line which is simply the 9-day EMA. The MACD line is the fast line and the 9-day EMA line is called the slow line.
If both the lines are above 0, the stock is most probably bullish. Similarly, if the fast line crosses above the slow line, the stock is in a short-term uptrend and vice versa.