In this article on Moving Averages
- Understanding Averages
- What are Moving Averages?
- How to Use Moving Averages in the Stock Market?
- Most Common Combinations of Moving Averages
- Disadvantages of Moving Averages
- Moving Averages Compression
Understanding AveragesNow before we understand what are moving averages, let us first understand what are averages. Imagine the Indian cricket team is playing a T-20 international match. The top five batsmen have scored the following runs–
|Dec 20, 2021||1425.65|
|Dec 21, 2021||1441.80|
|Dec 22, 2021||1445.20|
|Dec 23, 2021||1444.10|
|Dec 24, 2021||1438.90|
|Dec 01, 2021||1504.65|
|Dec 02, 2021||1525.75|
|Dec 03, 2021||1513.55|
|Dec 06, 2021||1503.80|
|Dec 07, 2021||1525.70|
|Dec 08, 2021||1553.80|
|Dec 09, 2021||1526.85|
|Dec 10, 2021||1522.55|
|Dec 13, 2021||1511.15|
|Dec 14, 2021||1502.45|
|Dec 15, 2021||1500.00||1519.03|
|Dec 16, 2021||1500.10||1518.56|
|Dec 17, 2021||1473.05||1516.00|
|Dec 20, 2021||1425.65||1511.95|
|Dec 21, 2021||1441.80||1504.13|
|Dec 22, 2021||1445.20||1495.74|
|Dec 23, 2021||1444.10||1484.88|
|Dec 24, 2021||1438.90||1476.61|
- You must add HDFC Bank’s share price for last 10 days (1st – 14th December)
- Now divide the total by 10.
- You will exclude the share price on 1st December 2021
- And you will include the latest share price of 15th December 2021.
What are Moving Averages?Moving average is the average price of a stock at a specific point in time. It tries to discover a trend in the share prices. Moving averages give unique signals that are used in combination with other traditional chart patterns like Relative Strength Index etc.There are multiple types of moving averages. Here’s a list of the types of moving averages used in technical analysis –
- Simple Moving Average (SMA)
- Exponential Moving Average (EMA)
- Weighted Moving Average
- Time Series Moving Average
- Triangular Moving Average
- Variable Moving Average
- VIDYA Moving Average
- Welles Wilder Moving Average
- Simple Moving Average – SMA
- Exponential Moving Average – EMA
Sensitivity of Moving AveragesThe shorter the moving average is, the greater is its sensitivity to changes in the stock price. For example, a 5-day moving average is much more sensitive than a 20-day moving average. There isn’t just one right time frame to pick a moving average. It all depends on two things –
- Are you a short-term trader or positional trader?
- Is the market trending or non-trending?
How to Use Moving Averages in the Stock Market?Moving averages help traders and investors in identifying buying and selling opportunities in the market. Here is how moving averages work –
- When a stock is trading above its moving average – This means that traders are ready to buy the stock at a higher price than its averages. This will only happen when traders are bullish on the stock. So, traders are expecting the stock prices to increase further and hence they are willing to pay more than the average price of the stock. So, if a stock is trading above its 200-DMA, it is a good buying opportunity.
- When a stock is trading below its moving average – This shows that the traders are willing to sell the share at a lower price than its average. When will a trader do this? Only when, he believes the share price will plummet further. Hence, he is willing to take a lower price than the stock’s average. This is a good selling or short-selling opportunity for traders.
- Whenever a stock’s moving average is consistently rising, it means that the stock is in uptrend.
- If a stock’s moving average is declining steadily, the stock is in downtrend.
- Moving averages work brilliantly when a stock is in trend. But not so much when the stock is trading sideways.
Most Common Combinations of Moving Averages in Trading
- The 9-day and 18-day SMA is used to identify short-term trends. A strong buy signal is generated when the 9-day moving average crosses above the 18-day moving average.
- A combination of 13 and 30-day SMA is used as a secondary trend indicator.
- The 50-day and 100-day SMA is used to identify long-term trends in the market.
Disadvantages of the Moving AveragesThe biggest assumption when using moving averages is that markets are often in trend. But in reality, markets spend more time in consolidations. Also, quick-turning markets will always be well ahead of the moving averages. Thus, giving delayed signals for entry and exit by which time the best part of the move is probably over. In the example below, the moving average crossover system has captured big moves during trending phase whereas during the non-trending phase there were whipsaw losses in the Nifty50.Now before we end our discussion on moving averages, let us study this one important concept – Moving Average Compression.
Moving Average CompressionMoving averages compression is when the 50-day, 100-day and 200-day moving averages converge or overlap. After this point, the stock can either be in strong uptrend or downtrend. Let us take the example of Tata Consultancy Services Ltd. Notice what happens on November 3, 2015 - All three moving averages, 50-day, 100-day and 200-day converge. The share price of TCS was Rs 1,246.87. After this compression, the stock price fell down to Rs 1,141.44 by December 3, 2015. This is a fall of 8.45% in one-month. The below chart is of Reliance Industries Ltd. A moving averages compression was formed in the stock on April 15, 2014. Its share price was Rs 457.49. Post this compression, the stock went into a major uptrend. Its stock price reached Rs 520.27 on July 22, 2015. That's an increase of 13.72%. So, whenever you are using moving averages in stock trading, don’t forget about moving averages compression. Watch this video by Mr Umesh Mehta where he talks about Moving Averages Compression
Moving Averages as Support and ResistanceYou can also use moving averages as support and resistance during trading. Support is the price level below which a stock is not expected to fall. And resistance is the price level above which a stock is not expected to rise. Many times, a stock will trade in line with its 50-day EMA and then reverse. Take the example of the 200-Day Moving Average.
- Stocks in secular bull markets tend to hold above the 200 DMA.
- While stocks in a secular bear market usually trade below the 200 DMA for extended periods of time.