One Moving Average Alone Is Not Enough
Many traders tried to use the SMA to predict the sell or buy options on a chart. You can pull this off by using various averages for triggers.
By Guy Avtalyon
Moving averages are one of the most popular trading tools, so let’s see how to use moving averages in trading stocks. Some traders have great knowledge about it but some still make it wrong. The latter might have an extremely great influence on trading success and traders’ confidence in this strategy. But actually it’s a great strategy if you know how to use moving averages in trading stocks.
Our aim is to show you exactly that and how to avoid mistakes. We’ll show you how to choose the type and length of the moving average. Also, we’ll show you how to use moving averages in trading stocks and how they can help you to make trading decisions.
Which moving average to choose?
Not a small number of traders will ask what moving average to choose, EMA or SMA. To evoke. EMA is an exponential moving average while SMA is the simple moving average. There are not too many differences between these two but if you choose one or other that can make a difference in your trading result.
The main difference between EMA and SMA is speed. Moving average EMA will always move much faster and thus will change the direction before than SMA. Hence, EMA is capable of faster recognizing the stock price change. On the other hand, SMA would take much more time to turn when the stock price changes.
But you cannot conclude which is better based on their speed. How is that? EMA acts quickly when the stock price changes direction, which means it’s more sensitive. When something is sensitive it’s at the same time more vulnerable. That’s the reason why EMA could send a wrong trading signal. Simply, it reacts too soon.
For example, if the stock price starts to go down, the EMA will begin turning down promptly and it will indicate a change in the direction too early. What if it is a short-term living change? What if it is a false signal? So, we’ll need to watch the SMA. It moves slower thus it provides a more accurate signal.
Well, it will be nice if so simple but it isn’t. If you trade according to EMA only, you’ll be at risk to enter a trade too early. Also, if you use SMA only there is another problem because you might enter the trade too late. There is an additional benefit to using SMA. During the volatile markets, its signal is less wrong.
How to trade with the SMA?
SMA is a generally accepted technical indicator, as we said. Do you remember how we use it in school? It’s similar.
By using SMA you’ll be able to recognize the strategy that will work for you. In the beginning, here is the formula and later we’ll show you how to use moving averages in trading stocks.
The SMA formula is the average closing price of a stock over the given periods. So, add all closing prices on the particular stock during the week, for example, and divide the result by the number of days (a trading week is 5 days long). This may look like this for 5 days:
(19 + 20 + 22 + 18 + 21) / 5 = 100 / 5 = 20
You can calculate SMA for 10 days, 15 days, 50 days, etc. It’s simple math. Well. all indicators are based on math.
With SMA, you cannot do whatever you want. It is important to use the most practiced SMAs, not some unnatural 33-days, for example. That cannot beat the market. Traders use 10, 15, 20, 50, 100, or 200 SMAs every day. And you have to know what is interesting for other traders, what they are looking for.
The point is, the shorter the SMA, the more signals you will get. For instance, if you use 5-days SMA use it along with a longer SMA because you’ll need a proper trigger for your trade, not an indicators’ noise. Short-term traders will use SMAs for up to 20-days.
How to use moving averages
The right question is how to make money with SMA. Find stocks that are breaking out or down but it has to be done strongly. Use SMAs, test them all, to recognize which setting carries the best price. Now, when this is done, let the price test a particular SMA, if done successfully you’ll have a confirmation of the trend. Enter the trade on the first following bar.
Also, you can use two SMA to fade the primary trend. You’ll have to be positive that the stock price didn’t touch 5-days or 10-days SMAs in the latest 10 bars. The price should close below or above both SMAs but in the opposite direction of the primary trend in the same bar. Enter the trade on the first following bar.
These are two approaches: with the trend or fade the trend when trading with SMA.
How to use moving averages EMA?
The EMA is maybe the oldest indicator of technical analysis. The EMA strategy is helpful to identify the prevailing trend in the stock market. When executing your trades, EMA will provide support and resistance level to do that. The exponential moving average strategy works in all markets and in any time frame, actually. It is a line on the price chart that uses a math formula to help you smooth out the price performance. The EMA formula pays more attention to the recent stock prices. As we said above, it’s faster.
The EMA helps to reduce the noise of daily price action and shows the trend but also, perfect in determining future changes in the market price.
How to calculate the EMA?
Use the SMA as the start-point for the EMA value. Let’s assume we want to observe 20-days. So, we’ll need to calculate the SMA for 20 days. On the first next day, the 21st day, we have to use SMA from the prior day as the first EMA.
The calculation for the SMA is simple since it is the sum of the closing prices during a chosen period, and divided by the number of results obtained for that period. For instance, a 20-day SMA is the sum of the 20 closing prices for the last 20 days and divided by 20. Further, you must calculate the multiplier for weighting the EMA. Here is the formula
(2 / (number of results + 1)).
In the example of the 20-day average, it looks like this:
2/(20+1) = 2/21 = 0,0952
Let’s calculate the current EMA.
EMA = closing price x multiplier + EMA (prior day) x (1-multiplier)
The EMA puts a higher weight to recent prices, while the SMA gives equal weight to all values. The weighting is higher for a short-period EMA than for a long-period EMA.
EMA strategy
Use one moving average with a long period and one with a short period to remove subjectivity from the trading.
Draw on your chart 20 and 50 EMAs. Do it precisely to be able to identify crossover when it occurs and wait for the price to trade above 20 and 50 EMA. The area between 20 and 50 EMA should be retested twice or more times. If two tests are successful and successive that means the market has sufficient time to develop a trend.
We hope you can now understand how to use moving averages in trading stocks. They are fundamental for strategies based on technical analysis. If you use moving averages in combination, you’ll be able to predict both short-term and long-term stock price movements.
How to use moving averages in trading stock more? Use them to define levels of support and resistance.
Stay tuned, that will be the next topic.
