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The success of a market technician resides in large part to his committing to a particular trading horizon and using the appropriate technical signals to trade it.
So, for example, if a technician is interested in investing for the long term, he should rely more heavily on monthly charts to identify the prevailing secular trend, and weekly charts to determine appropriate entry points. A day trader, by contrast, would more likely employ a quarter-hour or hourly chart to determine direction and then one- or five-minute intervals to spot his entry and exit points.
But what sorts of tools give us an indication of the prevailing trend of a security, the determination of which is crucial to successful trading?
Moving Averages: Their Composition and Use
We’re going to look at just one of those tools today, and there may be none more important in determining whether a security is currently bullish or bearish: the moving average.
In the charts below we’re going to highlight two key moving averages and the ways traders employ them to make money. But first, what is a moving average?
A moving average is a collection of closing figures for a security over a given period – say, 50 days – that are added together and then divided by the total number of data points. The resulting number is plotted on a chart, and the next day the process is repeated, with the first data point omitted and the latest added to make the new calculation. The resulting line that is formed is called a “simple moving average.”
An “exponential moving average” is a slightly different affair. The same process is followed, but a multiplier is added to the inputs in order to give the latest figures more weight.
It should be noted that there are any number of variations on this process, each of which produces its own moving average sample, but the simple and exponential varieties are the most widely used.
Whichever one you choose, the key is consistency, as regularly referring to more than one, or switching between several, will likely result in confusion and a less deliberate buy/sell discipline, which should be avoided at all costs.
Now to the charts:
A look at the top chart shows the 50- and 200-day moving averages moving higher in tandem. You can also see the price pattern of higher highs (green dots) and higher lows (red dots). Together, they depict a bullish trend for the security in question here, Facebook (NASDAQ: FB).
On the bottom, you have the opposite: down-trending 50- and 200-day moving averages, along with lower highs and lower lows, creating a textbook bearish pattern for the United States Oil Fund (NYSEArca: USO).
These indications are reliable, and reveal to the trader the prevailing trend of the security from a daily perspective. Choosing an appropriate entry point for a long Facebook or short USO trade can now be a far more conscious and deliberate operation.
Trading note: Just a quick word on the importance of the period selected for moving averages. Many people rely heavily on the movements of the 50- and 200-day moving averages. They have become enshrined, so to speak, as the universal choice of technical analysts the world over.
But the truth is somewhat different. As we’ll show you in our next installment, it matters little which moving averages you use to trade securities. More important is that you’re consistent in employing them.
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