Since we already know what are the moving averages and how they are calculated, let’s have a look how they behave and how using moving averages comes very handy for traders.
Truth is that it is not predicting the price for you, it rather shows the real price of the stock with a certain delay. However, based on both price level and moving average level, it is considerably available to see the price direction and find support or resistance levels.
The delay is different for Simple and Exponential Moving Average. Below is an example of Ford with 50 period SMA in blue and 50 period EMA in green. The main difference between the two indicators is that the EMA is more responsive to price change.
Using moving averages differ based on how many periods are used. More periods you use – longer time frame is taken into account. Longer period MA is farther from a price curve then shorter one. Thus, it depends on the trader’s strategy what period MA is used. In long term, it is 200 and 150 MA; in the medium term it is between 100 and 50 MA; in short term, it is between 50 and 10.
The most important moving average is 200 SMA and should be part of every trader’s chart, not because of big and nice number, but because it is used globally. It is also a border between bull and bear, if the market is above the 200 SMA, we can usually say we are in an uptrend – bull market. Or the other way of course.
Ford Motor Company, Source: Stockcharts.com
Above you learnt about simple and exponential moving average. Let’s take the averages now and see how to use them as support and resistance levels.
Note, this can be used only in the upward or downward trending market. In a sideways market, moving averages do not work. However, there is different technic used to identify support and resistance.
Below is a daily index showing price, volume and different periods simple moving averages.
iShares S&P TSX Global Gold Index Fund, source: Google
Gold has started its bull run in the beginning of 2016, where we can clearly see the moving averages playing a role of support indicator. It was the 50 SMA that gold price bounced from at least three times during given period. These the best opportunities to enter the market and go long.
In the second half of August the price broke down through 50 SMA, this signals the market is not that excited as before, however, still keeping its steam and finds its new support at 150 SMA. This could be considered as the current level of support, is it going to bounce up again or slide down to hit the 200 SMA? Let’s see! As long as the index keep above 200 SMA, it is considers as the bull market.
Now, let’s have a look at resistance example.
Seadrill Ltd, Source: Google
The stock has entered the bear market in the beginning of May 2016 breaking its 200 and 150 SMA. Since that time it hit its 50 SMA several times while constantly going downwards. The 50 SMA represents here a resistance level and opportunity to short the stock. However, since the volume is pretty high as touching the 50 SMA, it is likely the stock will break through and bounce off at 200 SMA, which would be its new resistance level. If it breaks through the 200 SMA, the current trend is over and the bull market is likely to begin for Seadrill.
Using moving averages is very essential in the financial markets and should become a habit of every successful trader.