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Moving Average: A Simple Lesson

Because the market seems pretty bad nowadays, it’s better if we take our time to learn a little bit rather than keep an eye on the stock prices. This time I will discuss about moving average, one of the basic techniques in technical analysis to determine whether a stock price has greater opportunity to strengthen, or weaken. Yes, indeed I am a fundamentalist, but of course I also understand technical analysis even just a little bit.

Moving average, just like its name, literally means 'moving average'. What is that? It’s pretty much the same as regular average, only applied to the changing numbers, so the average is also changing (moving). For example, the closing price of stock X for last 5 trading days (one week) were 1,000, 1,100, 1,150, 1,100, and 1,200. Then we can state that the average stock X price during the week is all the numbers added up (1,000 + 1,100 + 1,150 + 1,100 + 1,200), and then divided by five. The result is 1,110.

So, as for example the stock X price on the next trading day turned into 1,250, then the average also changed into: the new price is included in the calculations to change the most recent price (1,250 is added, and 1,000 is released). So it will be 1,100 + 1,150 + 1,100 + 1,200 + 1,250, then divided by five, and the result is 1.160. Therefore, the average has moved from 1,110 to 1,160. That condition will continue; the average is always changing following the change in share price, so that it becomes moving average.

There are three kinds of moving average, namely Simple Moving Average (SMA), Weighted Moving Average (WMA), and Exponential Moving Average (EMA). Besides those, there are also Cumulative Moving Average (CMA) and the Modified Moving Average (MMA). The method been reviewed above is SMA or simple moving averages, with 5-day period. So how do we calculate WMA, EMA, and so on? I will not explain it here because its mathematical calculation is fairly confusing. Clearly, WMA and EMA movements are more responsive to the stock price movements compared to SMA, but the point is that all three (and others) are the same ‘moving average’. So here, we will discuss about SMA only.

What is the usefulness of SMA? And how to use it?

SMA is very effective to predict the movement of stock in the short term, especially if the stock type has good liquidity and sharp yet reasonable fluctuations, which makes it suitable to be analyzed in the short term (eg Medco Energi Internasional/MEDC). The usual method I use is by comparing the long-period SMA with the short-period SMA. For example, on the MEDC chart movement over the last year, I attributed two SMAs, which is the 50-day period of SMA, and 20-days period of SMA. (I randomly select the number. The point is one number is greater than the other).

Consider the following picture, click to enlarge:

1. The blue line shows the MEDC stock movement chart over the last year.
2. The red line shows the SMA with longer period of 50 days
3. The green line shows the SMA with shorter period of 20 days

Well, here's how, note the circled part: Every time the green and red lines intersecting where the position of the red line is on the top of the green line, then MEDC is likely to strengthen. On the contrary, every time the green and red lines intersecting where the position of the red line is below the green line, then MEDC is likely to weaken.

Note the circle no.1. There appears that the red line is above the green line. And then what? Soon after that, MEDC rose significantly. A few moments later, the green line keeps moving up and eventually overtake the red line (circles no.2). That's when the MEDC began to descend. Not long afterwards, the red line back to overtake the green line (circle no.3), and that's when MEDC rose back up, although it rises and falls prior to that. And so on.

SMA effectively predicts when is the right time to buy, and when is the right time to sell (ie when you know that the shares you hold will go up or down significantly). It means that every time you see those red and green lines intersect, then that's when you have to get ready to go in or out.

However, SMA is not always able to predict the increase or decrease of stock price. For example, consider the circle no.6. There appears that the red line is below the green line, which means the MEDC will move lower. And it's true; MEDC weakened shortly afterwards. However, MEDC is directly moving up rapidly, shortly after the weakened, although the red line did not intersect with the green line and its position is still below the green line. This suggests that the observation of SMA is not enough to determine whether the price of a stock will go up or down. In addition, SMA is only effective to be used on stocks that are suitably analyzed for the short term. In some stocks that only suitable to be analyzed for the long term, the use of SMA is less effective, even sometimes mistaken.

I used to use SMA only as an additional tool, to further strengthen my analysis about whether the price of a stock will go up or down. For example, with fundamental and psychological analysis considerations and others, I predict that stock X will rise in the near future. To be sure, I then use the SMA. Apparently, the chart does show that the red and green lines intersect where the red line is above the green line (and usually is almost always like that. Rarely happens when I predict that the stock X will go up but SMA shows the opposite). So I can conclude that: shares X will strengthened in the near future!

How do I see this SMA line?

You can easily see on Yahoo Finance. When you're looking at a stock price chart, click the 'Technical Indicators' menu above the graph, then simply click moving average, select how many periods you want (the default period is 50), and then click Draw. You can enter up to three SMA with three different periods.

Original article was written at May 25, 2010

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