Some info for all those technical analysis buffs:
MOVING AVERAGES - The Blanket, 26-Feb-1999
Whether you have a fancy charting service or use one of the many free
services on the Internet, you will find that many stock charts have one
to two linear lines depicted on the face of the chart. These lines are
called MOVING AVERAGES; one of the simplest technical analysis tools
available.
Analyzing the markets or individual stocks doesn't have to be
complicated and for many investors some of the simplest indicators can
often be the most useful in finding stocks that warrant further
investigation. MOVING AVERAGES are one of these indicators that, when
used in combination with others, can be a very powerful tool when
analyzing a potential investment.
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What is the significance of the MOVING AVERAGE indicator? All a moving
average does is smooth out the jiggles in a chart so it is easier to
view a TREND LINE. The longer the period used in calculating the
average, the smoother the line will be. A quick look at a chart reveals
how the stock is doing relative to its trend line or moving average.
On occasion you will read or hear about a security trading above, at, or
below its 30, 50, or 200 day moving average (DMA). Depending on your
investment horizon one moving average may be more suitable for your
analysis than others, and as we get further into this discussion I will
touch on the use of more then one MA as an effective tool in analyzing a
chart and making buy and sell decisions.
CALCULATION
To begin, it is important that one understands why it is called a
"moving" average and how it is calculated. Let's assume we want to view
a 5-DMA. In the table below I have calculated the 5-DMA for Friday
through Tuesday (2):
Day Closing Price Calculation 5-DMA
Monday 10
Tuesday 11
Wednesday 13
Thursday 12
Friday 13 (10+11+13+12+13)/5 = 11.8
Monday (2) 15 (11+13+12+13+15)/5 = 12.8
Tuesday (2) 16 (13+12+13+15+16)/5 = 13.8
As you can see, the figures for the last five days are used in the
calculation and as we "move" to the next day the closing price of the
oldest day drops from the calculation and the most recent price is
used. Note that in this example, even though the closing price goes up
and down over the five days the moving average increases. This is the
beginning of a trend line, which will ultimately be used to evaluate
whether the current price of the stock is following or going against the
trend.
LAGGING INDICATOR
Unlike an indicator that signals potential for a future change in a
stock price, a MOVING AVERAGE confirms that a change in a trend has
already taken place. I draw this to your attention so that you
understand that when viewing a chart with various MAs the longer the
time period used in (i.e. 200-DMA vs. 50-DMA) the more "lag" there will
be in the price movement.
To view this concept click on the following link to obtain a chart on
Amazon (AMZN):
bigcharts.com
Note - this is a different charting service than I have used in previous
articles but I'm going to give you hands on experience at changing the
indicators yourself.
On the left-hand side you will see several items you can click on.
Please do the following:
1) Click on time frame and select Time = 3 months, Frequency will remain
daily.
2) Click on indicators and select Moving Averages = SMA (Simple Moving
Average) and change the number 9 to 5 (number of days.)
3) Click on DRAW CHART.
Pinpoint the high price in early January and note how the moving average
peaks and begins its descent 3 days after the original downward price
movement. What you are viewing is the "lag" and thus the reason for
MOVING AVERAGES being a confirmation of a trend vs. a signal for future
change.
VARIATIONS
Thus far I have been using and directing you to a "simple" moving
average (SMA). Many charting services use a "weighted" (WMA) or
"exponential" moving average (EMA) that places heavier emphasis on more
recent prices.
Using the same AMZN chart just viewed, change your moving average
selection from SMA (Simple moving average) to EMA (Exponential Moving
Average). Click on draw chart and note that the moving average peaks 1
day earlier and begins its descent 2 days after the downward price turn
vs. the 3 days displayed on the chart using the SMA.
Because the EMA reveals an earlier indication of a price change, I will
make use of it as opposed to SMA as we move into using the MOVING
AVERAGE in evaluating potential investments.
EVALUATING A POTENTIAL INVESTMENT
Let us begin by drawing another chart: Best Buy Co.
1. Type BBY in the symbol field
2. Make sure that the Time frame is 3 months and "daily."
3. Set the Moving Averages to EMA and "days" to 50 (type 50 in the box
to the right of the Moving Averages field.)
The most important aspect of this chart is the slope of the line. A
50-DMA that is upward sloping indicates that the trend of the stock is
up and that the stock is strong. In evaluating Best Buy Co. you can see
that it is trading well above its 50-DMA. This doesn't mean that you
should run out and buy BBY now, but rather, that it is very strong stock
and could be a potentially good investment.
Now let us take a look at a stock that is trading well below it's 50-DMA
by drawing a chart for USX-Marathon Group:
Symbol = MRO
Time frame= 3 months, daily
Moving Averages = EMA, days = 50
Again, the most important aspect of this chart is the slope of the
line. A 50-DMA that is downward sloping indicates that the trend of the
stock is down and that the stock is weak. Also note that this stock is
trading well below its 50-DMA. Whereas BBY was a very strong stock,
USX-Marathon Group is very weak and should not be considered further as
a potential investment. The exception to this statement is that it
could be considered a good candidate for shorting (selling a stock in
anticipation of buying it back cheaper) which could be a newsletter in
and of itself!
In both of the previous charts I have used the 50-DMA. Using the 50-DMA
as opposed to a shorter time frame, like the 20-DMA, tends to smooth out
a lot of the jiggles in the shorter term moving average. But how does
one know what time period is best to use?
NUMBER OF DAYS TO USE IN MOVING AVERAGES
As a rule of thumb the longer your investment horizon the longer the
time frame that should be used for the moving average. The 200-DMA is
best known for monitoring major trends and it might be a suitable
indicator for a long-term investor. A short-term investor might choose
a 30- or 50-DMA, which are more commonly used to measure intermediate
trends. A day trader, on the other hand, might use a 5, 10 or 20-DMA.
Returning back to Best Buy Co., select:
Symbol = BBY
Time = 3 months, daily
Moving Averages = EMA, days = 20
Again, BBY is trading above the moving average. Now compare how it
traded against the 20-DMA during January as opposed to February. In
January it traded well above it's 20-DMA, which was a sign of SUPER
STRENGTH. In February it begins to hover at its 20-DMA, which is an
indication that the momentum is weakening. Now change the number of
days back to 50 and view the difference. Though the trend of the moving
average has not changed (they both slope upward) this weakening I've
just pointed out from January to February isn't clearly indicated by
looking at the 50-DMA alone.
So, you are probably asking yourself, "Why wouldn't I always want to use
a shorter time frame?" The answer lies in your investment horizon.
Remember there are those investors who may have substantial capital
gains accumulated and they would prefer not to realize these gains for
tax purposes unless they are convinced there has been a major change in
the trend.
USE OF MULTIPLE MOVING AVERAGES AS BUY/SELL SIGNALS
Often times you will see a chart that has more than one moving average.
This can be very useful in confirming that a buy or sell signal has
occurred. To illustrate, let us take a look at how Chase Manhattan
Corp. has traded over the past year by bringing up the following chart:
Symbol = CMB
Time = 1 year, daily
Moving Averages = EMA (2 line), days = 20
(This will give us the 20 and 40 day moving averages)
Note how the 40-day (blue line) "slower" moving average is much smoother
then the shorter 20-day (green line) "faster" moving average is. Also
note that on several occasions the lines cross over each other. The
"crossing over" of these lines can be used to confirm a buy or sell
signal.
The first significant "crossing over" occurs in early August 1998. At
this juncture the faster 20-DMA crosses and goes below the slower
40-DMA. This confirms a sell signal. Note how CMB traded for the
following two and a half months below both moving averages. This was
definitely not a time to go "bottom picking" in hopes of buying at a
good price.
On the flip side, focus on the change in slope that occurs in
mid-October 1998 where both the 20 and 40-DMA turn a corner and begin to
rise. Shortly thereafter a second "crossing over" occurs in late October
when the faster 20-DMA rises above the slower 40-DMA. This confirms a
buy signal. Also, note that CMB begins to trade above both moving
averages, which is bullish and indicates strength in the stock.
At this time I could go into more depth about crossovers and how Moving
Averages can serve as support or resistance levels, but I'll save that
for a future discussion.
So to wrap things up; analyzing stocks doesn't have to be complicated
and often the best indicators are the simplest ones. A MOVING AVERAGE
is a lagging indicator that can be very accurate and reliable in
confirming a change in or continuation of a price trend and which,
ultimately, can support a buy or sell decision when analyzing your
portfolio.
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