Charts: How to get the best out of moving averages
Following on from our introduction to technical analysis for beginners, this article looks at moving averages, describing why and how they can be used along with some basic strategies.
Contrary to popular perceptions even fundamentally driven fund managers will often use charts to quickly get a picture of price trends of stocks in their portfolio, focusing on those which look particularly weak or strong.
SIMPLE MOVING AVERAGE
The most basic moving average is called a ‘simple moving average’ and is calculated by adding together the daily closing price over x number of periods and dividing by the number of periods.
For example, to calculate a five-day moving average for insurer Direct Line (DLG), we add together the last five days’ closing prices, (310.4 + 311 + 311.6 + 311.7 + 308.5) and divide by five, which is 1,553.2 divided by five, or 310.6.
The free charting software on Shares’ website will calculate up to three different moving averages that you select.
HOW TO GET THE INFORMATION
To call up a chart on Shares’ website, first choose a stock in the search box.
Underneath the menu bars and the share price data is an intraday chart, and underneath that click on the link to Advanced Charts.
Above the bar showing the date range is the cog-shaped Settings icon with a drop-down menu. Click that Settings icon, then click Events & Indicators and scroll down to Simple Moving Average and check the box.
We have chosen 50-day and 200-day as the moving averages to display. Click update at the bottom of the box. Uncheck the volume box and any other checked boxes.
Then click on the year-to-date timeframe. Note that you can also change the timeframe by moving the brackets beneath the chart.
WHY USE A MOVING AVERAGE?
Essentially, moving averages smooth a data series removing short-term noise or ‘flip-flopping’ of the share price to reveal what technical analysts call the trend.
The trend is your friend, so the adage goes. The idea is to jump on a rising trend and ride it for as long as the trend remains in place.
One popular way to define a trend is to use a longer term and shorter-term average in combination such as the 200-day and 50-day.
Effectively the 200-day represents 40 weeks of trading data and the 50-day is 10 weeks. Stocks in strong up trends will show moving averages sloping upwards from bottom left to top right with the share price above both averages.
As you can see Direct Line’s share price has started to improve since July.
The 50-day moving average was pointing down but now looks like it is turning around and is sloping upwards while the share price is above both the 50-day and 200-day moving averages.
Trend followers look for shares where the price has established itself above both moving averages which are themselves sloping upwards.
GOLDEN CROSS AND DEATH CROSS
If the Direct Line share price was to move higher and remain above the two moving averages the shorter 50-day moving average would eventually move through the 200-day average. This is called a golden cross and is considered a bullish or positive development.
A good example of a strongly trending stock following a golden cross is packaging company Smurfit Kappa (SKG). The shares registered a golden cross in September 2020 and have since rallied by 54%.
When the 50-day falls below the 200-day it is called a death cross which is considered bearish or negative. A good example of a death cross is household products group Reckitt Benckiser (RB.) with the shares falling by 13% since the 50-day moving average fell below the 200-day in early December 2020.
USING THE MACD INDICATOR
The MACD, which stands for moving average convergence divergence, is a popular trend-following indicator constructed from two moving averages. Unlike the simple moving average, it uses exponential moving averages which means greater weight is given to recent data.
The settings are pre-set on the website to the standard ones, but users can change them to any they so choose.
Follow the same instructions as earlier to load a stock chart and click on the MACD from the Events & Indicators drop down menu.
The slower moving line is called the signal line and is plotted against the faster moving MACD line while below the chart a histogram shows the difference between the two averages. The averages converge and diverge through time, hence the name.
A buy signal is registered when the MACD line cuts up through the signal line. Crosses above zero are considered stronger signals than those that happen below the line.
Conversely sell signals are given by the MACD line breaking down through the signal line and crosses below zero are considered stronger than those that break above zero.
As an example, flooring products specialist Victoria (VCT:AIM) registered a buy signal when the MACD line moved up through the signal line.
Moving averages can be useful to get a quick overall snapshot of how a stock has traded historically as well as creating simple trend-following strategies for traders.