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Moving Averages & Exponential Moving Averages

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As for moving averages, our friend TATE said it well: I'm no expert on the mechanics of moving averages but this is how I look at them. If a stock is below its 200-day average it hasn't recovered from the recent "correction" so it may be a bargain or deserve to be where it is. I then look at where it is in relationship to the 50-day average, which is a good indicator of the direction it's heading in. Below the 200 and above the 50 tells me to look at the news and see what's going on.

A little more info:

The X-day moving average is simply the average price of a stock, over the previous X days, recalculated daily, and plotted on the price chart. A number of on-line charting services provide charts with the 50 day moving average super-imposed on the chart. I think the best is www.quote.com. They have a free trial available and you can configure the chart and moving average however you want to.

Also try www.alphachart.com for moving averages and other technical studies as well as Interactivequote, which we already have a link to. It's not realistic to calculate this yourself, so if you don't have a computer program that tracks stocks and downloads data on a daily basis, you'll have to find it online. The "Magic" of the 50-day moving average probably comes from the fact that so many traders follow it for buy and sell points. 21-day and 200-day moving averages are also popular.

Still a little more info:

The moving average is probably the best known, and most versatile, indicator in the analysts tool chest. It can be used with the price of your choice (highs, closes or whatever) and can also be applied to other indicators, helping to smooth out volatility. As the name implies, the Moving Average is the average of a given amount of data. For example, a 14 day average of closing prices is calculated by adding the last 14 closes and dividing by 14. The result is noted on a chart. The next day the same calculations are performed with the new result being connected (using a solid or dotted line) to yesterday’s. And so forth. Variations of the basic Moving Average are the Weighted and Exponential moving averages.

And still a little more info:

The exponential moving average (EMA.) They are most often set at 50 and 200 day averages, though many different numbers can be and are used. These lines identify the overall direction of prices. The most important observation is whether prices are above or below these two moving averages.

To define what an exponential moving average (EMA) is, it will be helpful first to define a simple moving average (MA). A simple moving average shows the average price over the last n days:

Simple MA = (P1 + P2 + ...... + Pn) / n

The problem is that simple moving averages are "jumpy." They respond twice to each piece of data - once when it is added, and again when it drops off. Having the moving average change when a price is removed is a bad thing. When a high price is dropped, the MA will most likely tick down. When a low price is dropped, the MA would probably tick up even if the price went up that day, but by an amount smaller than the value that was dropped. As Elder says, "A simple moving average is like a guard dog that barks twice." The solution to this unreliable alarm is to use Exponential Moving Averages.

An exponential moving average gives more weight to the latest data and responds faster to changes than does a simple MA. At the same time, EMA does not jump in response to old data being dropped off. Again, as Elder says, "This guard dog has better ears, and it only barks once when someone approaches the house."

EMA = price today * K + EMA yest * (1-K)

where K = 2 / (N+1)

This is a continuous formula: each day the latest price is factored in, and old data fades towards oblivion, as it should. The older the data, the less importance is attached to it.

Moving averages are useful because they typically act as floors below prices when they are rising, and as ceilings above prices when they are falling. When a stock is in a strong up trend, it's easy to fall into the trap of picking it up when it is up a couple of points, before a dip that could provide a better buying opportunity. Using the 13-day EMA, you can establish a price the stock is likely to gravitate back to, and as a result, determine a more favorable time to buy in.

Beware when a stock you own drops below its 13-day EMA! If it's a small cap, your risk goes up. When holding untested and volatile small caps, or extremely over-valued Internet stocks, it pays to err on the side of caution, and sell. Once you've dumped out of a losing stock or a stock that's experienced a loss, forget about it. Later on, go back and look at the losing trade to see what went wrong. By this time, it will be a rewarding experience as the stock will probably be below where it was when you got out. And even if it is higher, who cares? The reason for closing it out was a good one.


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