A moving average is a trend that is applied to the stock
data which represents an average of the share price points for specified
periods. The primary functions of a moving average is to analyze the trend and
momentum of the share price and to indicate to the user certain buying and
selling opportunities. Because the moving average takes a certain number of
periods and applies and average to them it is what is known as a lagging
indicator as it confirms trends and is not used to predict them. The basic
application is similar in a sense to the stochastic indicator which is
previously discussed as seen in the menu.
By looking at the example below lets
establish the basics regarding the moving average. Below one can see a blue
line that follows the share price, this is the moving average. Similar to the
stochastic logic with a moving average on an upward trend when the candle
sticks or line chart is above the moving average then the upward momentum of
the share price is increasing. likewise if the share price is trading below the
moving average then the upward momentum is decreasing. The same logic also
applies to downward trends.
When the candle stick or line chart is trading
below the moving average then the momentum downwards is increasing relative to
the moving average. If the share price is trading above the moving average then
the momentum downwards is decreasing relative to the moving average.
There are three types of settings that will be covered. The 21 and 50 period settings and the very important 200 period moving average. The first setting combination to be discussed is the 21 and 50 period moving average combination. This moving average combination is used to identify potential entry and exit points. Simply, this method covers less periods than the 50 period moving average and is thus more sensitive. This means that it will be a faster acting indicator. The 50 period moving average will be a slower acting indicator and is less sensitive to price fluctuation. Now combining these two indicators can be a powerful method for determining trades. The example below is a pictorial representation of this method.
When the blue line (21 period moving average) is above the
red line this indicates that the momentum is moving upwards thus an increasing
share price. Likewise when the blue line is below the red line this indicates
that the momentum is moving downwards thus indicating a decreasing share price.
The way these are used is to look at the points at which these two indicators
cross over one another. This can be seen in the example at the red and blue buy
and sell signal lines. When the blue line moves from below the red line and
crosses the red line this is an indication of a potential buy. When the blue
line moves from above the red line and crosses the red line this indicates a
potential sell. As one can see in the graph the timing of the signals was not
always optimal but if one had traded according to this indicator method one
would have been highly profitable. If one had gone long on all the buy signals
and shorted on all the sell signals the profit would have been 49% in 572
trading days where as holding the share for the entire period would have
produced a -4% return. This shows that this method can be highly effective even
if it is just used on its own, but combining this method with the other technicals
shown on this site can create a highly effective trading strategy.
The relative strength index is a technical indicator that
measures a shares momentum. It measures a shares current strength to its
historical price movements and uses the share prices closing data. Similarly to
the stochastic this indicator gives a measure of the overbought and oversold
conditions of a share. It too is also bounded between 0 and 100. A share is
usually considered oversold on the RSI when its value is below the 30 mark on
the vertical axis. A share is considered overbought on the RSI when its value
is above the 70 mark on the vertical axis. The RSI can display a lot about a
shares price further than the overbought and oversold conditions which will be
discussed later on.
One of the applications of this indicator is when the RSI
moves below the 30 mark or reaches a RSI low on the vertical axis this triggers
a buying signal to the trader. Likewise if the RSI is above the 70 mark or has
reached an RSI high on the vertical axis this triggers a selling opportunity to
the trader. The 30, 70 lines are the general settings however these values are
not set in stone and can be changed to accommodate a certain share An example of the 30, 70 line application can
be seen below.
As with the previously discussed stochastic indicator a moving average can also be applied to the relative strength index indicator. The application is the same as with the stochastic indicator. For the example shown below a 14 period relative strength with a 7 period moving average was chosen which gives accurate trade entries and exits. Furthermore for this share the overbought bound was changed from 70 to 64 and the lower bound to 34 from 30. This was done as the share rarely reached the standard bound settings and historically the new bounds were shown to give a better indication. To recap the method, when the RSI moves from below the moving average and intersects the moving average underneath the 34 mark on the vertical axis this indicates points of trade entry. When the RSI moves from above the moving average and intersects the moving average above the 64 mark on the vertical axis this indicates a sell point. The application of this is shown below.
