How to Use a Moving Average to Buy Stocks

Moving Average plays a crucial role in technical analysis.Moving average is one important tool that can never be ignored but its use can be tailored as per the strategy of an individual trader. This blog will deeply cater to inform you about the use of moving averages to buy stocks. 

Let us first have a glimpse of the moving average:

Moving Average

Moving Average is an indicator or a line plotted on the chart which takes out the average of the past data considering the prices and time period. The line of moving average determines the support and resistance levels based on which informed decisions can be made. It is an entirely customizable indicator that is more sensitive to price changes.

How to calculate the Moving Average?

A moving average calculates the average price by considering the past data of price and time period.

For example:

Moving Average = Sum of prices over N periods / N

Where:

• N = Number of periods (e.g., 10, 20, or 50 days).

Steps:

1. Select the time frame (N) for the moving average (e.g., 10 days).
2. Add the closing prices of the asset for the last N periods.
3. Divide the total by N.

For a 5 day period:

• Prices: [10, 12, 14, 16, 18]
• Moving Average = (10 + 12 + 14 + 16 + 18) / 5 = 14

Time Period in Moving Average

A trader can choose the length of moving average as per their strategy and price action. Moving average length determines the period for which the average is taken to analyze the trend. The length can vary from 10, 20, 50 to 100 and even 200 applying to multiple time frames on the chart depending on the trader’s choice.

Sometimes, the effectiveness of moving averages depends upon the choice of time frame. The longer the period of moving average, the greater the lag, it reduces as the period of moving average decreases.

To use moving averages with efficiency, traders can also experiment with multiple periods of moving averages and look out the strategies that work best for them.

Types of Moving Averages

The main types of moving averages consist of Simple Moving Average and Exponential Moving Average. SMA takes into account the closing prices of a security for the relevant period and divides the sum by the period number.

Exponential moving average is comparatively complex as each price in the moving average is given equal weightage and it becomes complex as it equally considers recent price movements.

Weighted Moving Average gives more weightage to recent data points and less weighting on the past data points. It is calculated by multiplying each observation in the data set by a predetermined weighting factor.

Pros and Cons of Using Moving Average to Buy Stocks

As an important tool among technical indicators, moving averages has some of the important advantages:

Support and Resistance

Moving Averages determine support and resistance levels, and marking these trend lines generally helps many traders identify potential price bouncebacks.

Simple to Identify

The marking of moving averages or trendlines can be easily executed on the chart.

Let us go through the certain limitations of moving averages:

Lagging Indicator

As the technical indicator depends on past prices for its movements, it inherently lags because it does not consider the recent movement in prices.

Sensitive to Different Time Frames

The data of moving averages varies as per the timeframes used for chart analysis. A stock might appear to be bullish on a daily chart but bearish on a higher time frame.

How to use a moving average?

To buy stocks, moving averages can be used in various forms depending on the strategy adopted by the traders. A moving average indicates the trend of the security either in upwards direction or in downwards direction. It is preferable to use short-term moving average compared to long-term moving average to avoid the noise among the technical charts.

Support and Resistance

Moving averages clearly determine potential price support and resistance levels that make it an effective signal to buy or sell a stock. In a trending market, the price moves within a range and usually bounces off the support level or pulls back from the resistance level.

The reason for this bounce from the line of moving average is pending orders of algo traders. Most of the algo traders have pending orders at the support level which gives a bounce in the prices.

Moving averages make it easy to identify these levels while helping traders to make the correct position in the direction of the trend. Traders enter into a long position when the price hits at the support levels the trend moves upwards and vice versa.

Trend Identification

Moving averages give an idea of trend direction which gives traders a basic idea to move with the trend. 

If you analyze an angled-up direction of the moving average, it signifies a defined uptrend in the security, a downward angle represents a downtrend in the security. 

While a sideways trend signifies a defined range of the price. The main aim of the moving average is to help traders recognize the trend.

As it can be seen from the above image, once the price trades above the line of moving average, it becomes the support area. In further pullbacks, the moving average acts as the support level to push the prices upwards.

Conversely, once the price starts trading below the moving average, the line acts as a resistance level as it prevents the prices from going upwards. The price comes down after touching the moving average line.

Crossover Strategies

Traders often use crossovers as one of the reliable moving average strategies that signal a potential change in the trend. 

When the two EMAs cross above or below with a change in price, it describes a crossover either golden or death. The most preferable EMAs to identify the crossovers are EMA 20 and EMA 50. Both the EMAs analyze recent price movements by removing extra noise present in the charts.

In Golden Crossover, traders keep their position as long as EMA 20 crosses EMA 50 in upward direction and hence signify an upward reversal in the security, and vice versa in the case of death crossover which signals a downward reversal in the security.

Why use a Moving Average?

Moving Averages in trend analysis is very useful to cut the extra noise on the price chart. But a real question arises: Why should I trade based on moving averages?

As a trader, you look for momentum when you enter into long or short positions. Algo traders have already placed orders at certain levels based on moving averages which gives the required momentum to an individual trader. In algo trading, orders are already placed at the moving average, and recognizing these levels allows one to pick the best opportunities.       

Therefore, using moving averages to buy or sell a stock is preferable as traders can enjoy quick profits by recognizing correct price levels through moving averages and trend identification. 

Moving Average Convergence Divergence (MACD)

MACD is one of the technical indicators that identify the price trend which potentially recognizes entry points for buying and selling. It shows the relationship among two exponential moving averages of a security’s price.

The use of a combination of two exponential moving averages which are 20-EMA and 50-EMA proves can be considered reliable. As 20-EMA reacts faster to the change in trend, a significant bounce can be seen in the price when 20-EMA crosses 50-EMA.

Moving Average with Demand and Supply

Moving average is a strong technical tool for the identification of the trend in security. The demand and supply theory considers the combination of 50 SMA, 50 EMA and 20 EMA to correctly identify the price action in a security.

When the price hits a demand zone and gives an upward reversal with the trend reversal confirmed through the moving average, or looking for demand and supply zones which even have golden and death crossover can be used as an add-on for that to zone to be traded. Using demand zones and moving averages simultaneously to study the price action gives the maximum efficiency which gives the best results. 

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