How to Use Moving Averages in Trading & Convergence Divergence?

 Moving Averages is another important technical indicator used by the traders while taking the buying and selling decision in stocks. From long-term trading to short-term and intraday trading, moving averages can be used to get a comparative idea about its historical price movement and latest price to decide whether to buy, sell or hold the stock.

Understanding the moving averages precisely to make the right decision for trading is important to utilize the power of this technical indicator. There are different types of moving averages applied in hourly, daily, weekly and monthly charts as per the trading strategy of the trader. Thus, in this article, we will discuss about moving averages, how to use them in trading with crossover strategy and various other aspects making it easier to understand the use of this tool.

What is the Moving Average Indicator?

Moving average is simply a stock indicator in technical analysis, showing the average price of stock over a period giving an idea of how much stock is trading above, below or close to its moving average price. The average price can be taken for a period like 10 days, 20 minutes, 30 weeks, or any period as per the trader’s choice and types of moving averages.

How to Calculate Four Point Moving Averages?

In calculating the moving average you need to understand these moving averages. The simple moving average is simply the average price of the stock over some time. For example, you can take 10-days, 20-days, 50-days, 100-days, or 200-days, period and add the daily closing price of the stock for that period and divide the same by the number of days you have taken to find out the simple moving average.

While, in the exponential moving average, you have to give more weight to more recent data that will track prices more closely than the related SMA. The most common EMA periods traders utilize are 50-days, 100-days, and 200-days periods if they look at stock from a long-term perspective and 12-day and 26-day EMAs if looking for short-term investment.

Lastly, the weighted moving average which is similar to the SMA, only prioritizes given to each preceding data with a different priority. This allows traders to create a customized weighting algorithm with non-linear distributions. WMA helps to track prices more closely than SMA and can be used to highlight support and resistance levels or identify the trend direction.

How to Use Moving Averages to Find the Trend?

Before buying any stock, first of all, you need to know the trend of the stock whether it is in a bullish trend, bearish trend or in a sideways trading range. According to the trend of a stock, you can decide to create a buying or selling position in any stock.

Using the moving average to find the trend, you have to plot a single moving average on the chart of the stock price you are looking to buy or sell. In today's technological era, you don't need to calculate the moving average values, when you use an advanced technical chart like candlestick chart patterns on your computer screen, in-built tools of technical indicators are available there you just need to select the desired one and apply on the chart.

You can also customize the parameters like the number of trading days, and apply the desired tool to draw that indicator. Similarly, you can draw the moving average as per your preferred period like 20-days, 50-days or 200-days. When you draw the MA line on the chart you can see a trend line is visible around the chart patterns showing the current trend in the stock.

When price action inclines to stay above the moving average, it indicates that the price is in an uptrend. On the other hand, when price action leans towards below the moving average, it signals that there is a downtrend in the stock. But don't rely on the single parameters, use a couple of more moving averages like short-term period moving average and long-term period moving average both can be drawn on the same chart to get a more precise trend.

Apart from checking the slope of the MA, you can compare the position of the price relative to the MA, if the price is trailing above the MA, it confirms an uptrend; while the price trailing below the MA, it confirms that there is a downtrend.  You can also use the crossovers of two MAs, in which if a shorter-term MA crosses above a longer-term MA, it signals a bullish trend reversal, while a shorter-term MA crosses below, it indicates a bearish trend reversal.

How to Use Moving Averages as Support and Resistance?

In trading finding the support and resistance describes the levels where the price of stock is more likely to stop moving in one direction or change the direction. At support levels, the price might reverse and move higher or you can say at this point the moving down momentum of price slowdowns. While at resistance levels, the price might reverse and move lower or at this point the momentum of the price moving up side is slowdowns.

You can use the moving averages of different periods to indicate levels of support and resistance. Usually, Moving averages running below the price create a support level and moving averages trailing above the price build a resistance level. You can add more than one-period moving average to find out more precise levels of support and resistance. For example, you can apply the 20, 50 and 100 days exponentially moving averages on the charts.

Using a shorter-period moving average gives support or resistance levels weaker than a long-period moving average. For example – a 100-day moving average provides a stronger support point compared to 10 days moving average.

Hence, use the different period moving averages like 10-days, 20-days, 50-days, 100-days and 200-days moving averages according to chart timings like hourly, daily, weekly or monthly. You can use the 100-days moving average on the daily chart to get the long-term stronger support and resistance where the price might move this far around every month.

At the support or resistance point, the moving average can be used to locate the areas that the price could move through or bounce back.

However, if the price moves to the moving average and does not bounce, there is a higher chance that it will move to lower levels of support. If the price has already reached at lower levels of support, let's say around 200-days moving average, then it signals a longer-term change in the trend. This indicates, that there is a chance the stock price is moving from an uptrend to down downtrend and vice versa or this phase is called the trend reversal.

Moving Averages in Trading

The main motive for using the moving averages is to find the trend and support or resistance on the price chart to create the right strategy for trading in that stock. You can combine all these signals, like trend, support or resistance to develop a profitable trading strategy for intraday trading or buy the stocks from a long-term investment point of view.

From simple moving averages to exponential moving averages or weighted average moving averages, apply them on daily charts and compare short, medium, and long-term trends over large periods. You have to use the right time frame to draw the moving average with a combination of short-period to long-period moving averages as per the trend line support or resistance.

Moving Average Trading Strategy

The trading strategy depends on your investment time horizon, yes are you going to use the moving average for intraday trading, for medium-term investment or for long-term investment. According to that, you have to choose the right parameter like the duration of the chart and apply the right duration moving average on that chart to get accurate results. Hence, below we brought the moving average trading strategy used by the traders globally.

Right Time Frame: Choose the right time frame to draw the moving average line, a shorter day moving average will be more sensitive towards price movement, compared to a longer period moving average that gives a stronger indication of the underlying trend and is more suitable for short-term trading and investing for long-term.

Identify the Trend: The main use of moving averages in trading is finding the trend in the stock price. When you see the price trading above the MA, it indicates there is potential for an uptrend. On the other hand, when the price moves below the moving average, means it indicates a downtrend. Moreover, you can use the slope of the MA line to know the momentum of the trend.

Determine the Support & Resistance: As we already discussed, MA acts like a dynamic support and resistance level. When stock is in an uptrend, MA works like a support level, where the price inclines to bounce back and continue the upward movement.

While in a downtrend, the MA works as resistance levels, stopping the price from reversing back into the downward trajectory. In trading, you can use the support and resistance as a stop-loss, entry point exit or book profits around these levels.MA Crossover Strategy: Apart from the bullish and bearish crossover, MA crossover happens when a short-period simple moving average crosses over a long-period simple moving average. Moving-average crossovers examples are Golden cross and Death cross.

When a 50-days simple moving average rises above the 200-day simple moving average, it is called the golden cross which is a bullish signal. When the 50-day simple moving average falls below the 200-day simple moving average it is known as the death cross giving a bearish signal in the stock that can further fall in the upcoming period.

MA using the Bollinger Bands: You can use another feasible trading strategy using the 20 days MA with Bollinger bands. This strategy is known as mean reversion using Bollinger bands, in which when the price will often return to the mean before bouncing back in the direction of the trend. Here, the middle Bollinger band (the 20-day SMA) can be used as support or resistance that can provide a useful buying and selling tool to form the right trading strategy.