Moving averages are a powerful tool for analyzing the trend in a security. They provide useful support and resistance points and are very easy to use. The most common time frames that are used when creating moving averages are the 200-day, 100-day, 50-day, 20-day and 10-day. The 200-day average is thought to be a good measure of a trading year, a 100-day average of a half a year, a 50-day average of a quarter of a year, a 20-day average of a month and 10-day average of two weeks.
Shorter moving averages will be more sensitive and generate more signals. However, there will also be an increase in the number of false signals and whipsaws. Longer moving averages will move slower and generate fewer signals. These signals will likely prove more reliable, but they also may come late. The EMA, which is generally more sensitive than the SMA, will also be likely to generate more signals. Each investor or trader should experiment with different moving average lengths and types to examine the trade-off between sensitivity and signal reliability. Once you have found a combination that works for you, then stick by it so you get a feel for the signals that those particular averages generate. There is no one moving average or combination with a special power; the key point is to represent the moving averages in various, multiple time frames.
THREE MOVING AVERAGES COMBINATION
Most traders use the combination of three averages. By combining multiple moving averages, you'll be able to come up with a clear answer to what the trend is in different time frames and whether the trends in the different time frames are aligned with one another. Futures traders use the combination like 5, 10 and 20 period averages. Stock traders use longer periods like the 50 day, 100 day and 200 day to generate trading signals. When the short period average crosses the medium one, this gives a trading signal but this need to be confirmed. Confirmation is obtained when the short and the medium move above the longer period average.
For short, medium or long term trades, one can use the combination of 20 and 50 period Exponential Moving Average (EMA) and the 200 period Simple Moving Average (SMA). Combining moving averages from multiple time frames will allow you to determine when the trends from all three periods are in your favor. By synthesizing all of these various moving averages, you will greatly increase your chances of profitable trading.
The 20 and 50 EMAs track the prices closer and help in determining structure (uptrend/downtrend) .They also aid in developing low-risk, high probability trade set-ups (entries) in a trending environment (for example, buying pullbacks to the 20 or 50 EMA in a rising trend.). You can see in the chart below how these lines can help you define trends. On the left side of the chart the 20 EMA is above the 50 EMA and the trend is up. The 20 EMA crosses down below the 50 EMA (after May 10) and the trend is down. Then, the 20 EMA crosses back up through the 50 EMA (in September 10) and the trend is up again - and it stays up thereafter. Focus on long positions only when the 20 EMA is above the 50 EMA. Focus on short positions only when the 20 SMA is below the 50 EMA. It doesn't get any simpler than that and it will keep you on the right side of the trend.
Here are the important things to remember (for long positions - reverse for short positions.):
Ø The 20 SMA must be above the 50 EMA.
Ø Their must be plenty of space in between the moving averages.
Ø Both moving averages must be sloping upward.
THE 200 PERIOD MOVING AVERAGE
The 200 SMA is the most important moving average to have on a stock chart. The 200 SMA is used to separate bull territory from bear territory. Studies have shown that by focusing on long positions above this line and short positions below this line can give you a slight edge. Also, many funds follow the 200 day or week SMA and that might be all the technical analysis they use, so it tends to cause ‘reactions’ and is an important level to watch. You will be surprised at how many times a stock will reverse in this area (look at the chart above).
Moving averages are one of the most powerful trend-following tools available to the trader. But they only work well when a stock is trending - not when they are in a trading range. When a stock (or the market itself) becomes "sloppy" then you can ignore moving averages - they won't work. Moreover, they should not be used in isolation. Instead, you should use moving averages in conjunction with Chart Pattern Analysis, Candlesticks and indicators such as MACD and Stochastics to create powerful and profitable Technical Analysis.
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