How to use moving average to buy stocks – Types and Examples

Moving averages, in stock market parlance, are only an extension of the average calculation most of us may have learnt at school. An average is the ratio of the sum of data to the number of data points. It helps in arriving at an approximate number that helps to make a decision.

Moving averages are an extrapolated version of a simple average. These are used to decide on stock buying and selling. It is called so since the time frame that we can use for making decisions can be moved. There is a 5-day moving average, 50-day moving average, or even one with a 20-minute time frame.

Moving averages are used as part of technical analysis to help an investor smoothen the stock price trend by taking off the daily price movements to make an informed and calculated decision.

Different types of moving averages used in stock analysis

When it comes to stock analysis, there are mainly three types of moving averages:

Simple moving average/SMA:

A simple moving average requires the average price of a stock across different timelines. It primarily uses closing prices of stocks. As a first step, it requires one to estimate the average prices of a stock as of given time periods. The next step is to divide the sum of prices by the total number of time periods. Let’s understand this with the help of an example:

Suppose Nisha wants to know the simple moving average for Stock ‘A’. For this, she considers the closing prices of the stock for the past 5 days.

The closing prices are Rs. 25, Rs. 26, Rs. 23, Rs. 24.9 and Rs. 25.3

The SMA can be computed as:

SMA = Rs. (25 + 26 + 23 +24.9 + 25.3) / 5 = Rs. 24.84

Weighted moving average:

A weighted moving average (WMA) helps in covering for some of the flaws of SMA by adding more weightage to recent data rather than the past. WMA strictly uses the different price levels of a stock than SMA.

Exponential moving average:

This moving average is also referred to as EMA. It uses complex calculations, however, just as WMA, EMA adds more weightage to the latest stock prices. If EMA and SMA are compared for the same time periods, the former shows faster reaction than the latter due to more emphasis on the recent stock prices.

Why are moving averages required?

Moving average plays an important role in stock markets, especially while making buy-and-sell decisions. As more investors focus on this calculation, most app-based trading platforms today contain a chart option reflecting moving average information.

There are various reasons why one should use moving averages while deciding on buying or selling of stocks. 

• By referring to moving averages, one does not have to worry about price fluctuations of a day or a week or a fortnight. With the help of the final readings of moving averages, one can know the final pricing.
• A moving average gives the average of closing prices of a particular stock as per the time criteria chosen. For instance, an investor can choose a 5-day moving average or a 10-day moving average, depending on personal preference.
• If the moving average graph shows an upward trend, it indicates rising prices. If the graph is moving down, the stock price is considered to be going down. For movement that is sideways, the price is considered within the range.

Stock markets in India widely make use of moving averages since it is a good indicator of stock performance. Without worrying about minute details, investors can look at the moving average graph and know the stock price prediction. It allows one to buy the right stocks and wait for it to fetch good returns before exiting the investment. 

Important factors to note while using moving averages

While moving average gives a quick and easy view on price trends of financial instruments, here are some of the factors that one must keep in mind while using them:

• Every stock market security comes with a unique price history. Therefore, there are no set rules across all securities and markets. A moving average may not always reflect the constant change in prices of securities.
• The main reason why investors want to identify a trend is to be able to predict future stock prices. However, if the price of a security does not move, calculating moving averages does not give an investor the opportunity to profit.
• Stocks may show a cyclical pattern that cannot be accurately interpreted by using a moving average.
• Moving averages can spread out over different time periods, however, this can be tricky in specific cases.
• These may also not consider the changes in primary influencing factors that result in changes in a stock price. For example, management structure changes, changes in the industry, changes in product demand in the market, etc.

Conclusion

For a new investor who has started learning to trade, using moving averages as part of technical analysis can prove to be complicated. Before adopting this strategy for stock selection, it is important to know the basics of the market and how it functions.

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