Moving Averages

Moving averages (MAs) are fundamentally a mathematical method for comparing data points over a specific time period by creating a series of averages. In stock market contexts, they are calculated by taking the arithmetic mean of a stock's closing prices over a set number of days. This creates a smooth line that 'glides' along the price chart.

The main purpose of this indicator is to filter out the short-term, random fluctuations in the price and illuminate the underlying trend. By focusing on the larger movement, MAs give a more structured picture of market sentiment than individual days' supply and demand swings can.

The most basic function of moving averages is to act as dynamic support and resistance levels. When the share price rises above its moving average, many technical analysts interpret this as a signal that the ongoing trend is upward and that the stock is in a 'bullish' phase. Conversely, if the course of the price falls below its moving average, this is often considered a sign of a 'bearish' trend or a downward movement.

This dual role as trend indicator and dynamic level makes MAs an indispensable tool for assessing market momentum and potential turning points.

The most basic strategy involves using two moving averages with different time periods, often a fast one (e.g. 20 days) and a slow one (e.g. 50 or 200 days). A buy signal is generated when the fast line crosses upward over the slow line, an event called a 'golden cross'. This signal is interpreted as the short trend having become stronger than the long one, indicating the beginning of a strong upward trend.

Conversely, when the fast line crosses downward over the slow line, this is called a 'death cross' and acts as a sell signal, suggesting a potential turn to a downward trend. This dual strategy reduces the number of false signals that can arise with a single line and gives a clearer visual indicator of trend changes.

A more advanced application is to use moving averages as part of a 'Bollinger Band' strategy. Bollinger Bands consist of a moving average (often 20 days) with an upper and a lower band that are two standard deviations from the mean. These bands expand and contract based on the market's volatility. When the stock's price touches the upper band, the stock is considered 'overbought' and may be susceptible to a decline.

When the price reaches the lower band, it is considered 'oversold' and may be about to recover. This method provides a dynamic framework for assessing whether a stock's current price is in line with its normal volatility range.