Moving averages
The advantages of using moving averages need to be weighed against the disadvantages. Moving averages are trend following, or lagging, indicators that will always be a step behind. This is not necessarily a bad thing though. After all, the trend is your friend and it is best to trade in the direction of the trend. Moving averages ensure that a trader is in line with the current trend. Even though the trend is your friend, securities spend a great deal of time in trading ranges, which render moving averages ineffective. Once in a trend, moving averages will keep you in, but also give late signals. Don't expect to sell at the top and buy at the bottom using moving averages. As with most technical analysis tools, moving averages should not be used on their own, but in conjunction with other complementary tools. Chartists can use moving averages to define the overall trend and then use RSI to define overbought or oversold levels.
Price Crossovers
Moving averages can also be used to generate signals with simple price crossovers. A bullish signal is generated when prices move above the moving average. A bearish signal is generated when prices move below the moving average. Price crossovers can be combined to trade within the bigger trend. The longer moving average sets the tone for the bigger trend and the shorter moving average is used to generate the signals. One would look for bullish price crosses only when prices are already above the longer moving average. This would be trading in harmony with the bigger trend. For example, if price is above the 200-day moving average, chartists would only focus on signals when price moves above the 50-day moving average. Obviously, a move below the 50-day moving average would precede such a signal, but such bearish crosses would be ignored because the bigger trend is up. A bearish cross would simply suggest a pullback within a bigger uptrend. A cross back above the 50-day moving average would signal an upturn in prices and continuation of the bigger uptrend.
The next chart shows Emerson Electric (EMR) with the 50-day EMA and 200-day EMA. The stock crossed and held above the 200-day moving average in August. There were dips below the 50-day EMA in early November and again in early February. Prices quickly moved back above the 50-day EMA to provide bullish signals (green arrows) in harmony with the bigger uptrend. MACD(1,50,1) is shown in the indicator window to confirm price crosses above or below the 50-day EMA. The 1-day EMA equals the closing price. MACD(1,50,1) is positive when the close is above the 50-day EMA and negative when the close is below the 50-day EMA.
Moving averages smooth the price data to form a trend following indicator. They do not predict price direction, but rather define the current direction, though they lag due to being based on past prices. Despite this, moving averages help smooth price action and filter out the noise. They also form the building blocks for many other technical indicators and overlays, such as Bollinger Bands, MACD and the McClellan Oscillator. The two most popular types of moving averages are the Simple Moving Average (SMA) and the Exponential Moving Average (EMA). These moving averages can be used to identify the direction of the trend or define potential support and resistance levels.
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