Friday, December 26, 2008

A Simple Use of Simple Moving Averages: Trend Determination

This isn’t going to be a long post. The method is fairly simple and the idea behind it just as simple. This will not make you large amounts of money instantaneously, but may help you determine a strengthening trend or a weakening trend.

All this technique requires of you is a chart of the stock or currency you would like to analyze and the overlay of three moving averages: the 50 period simple moving average (SMA), the 100 period SMA, and the 200 period SMA. Nothing else is required. Because you can use this on any type of time frame (e.g. 1 minute, 15 minute, daily, weekly, etc), I call the moving averages 50 period, or 200 period, rather than 50 day.

Once you have this information on your screen take a look at the location of the moving averages. Based on the following list, you will be able to ascertain important pieces of information from this chart:

- If the 50 period is below both the 200 period and the 100 period, the stock is trending relatively hard to the downside.

- If the 50 period is below the 100 period but not the 200 period, the stock is trending with some strength to the downside.

- If the 50 had recently been above the 100 and the 200 but is slowly converging with one or both, then the uptrend is losing steam. It is becoming relatively neutral.

- If the 50 is above the 100 but not the 200, then the stock is beginning to regain momentum to the upside. It is relatively bullish.

- If the 50 is above both the 100 and the 200 period moving averages, you have a stock that is strongly bullish.

As you can see above, the main goal is to compare the average strength of the past shorter period with two longer periods. Seeing the average increase or decrease in value tells you quite a bit. Remember that just because the trend is bullish or bearish based on the above, that is not enough information to put on a trade. While it is often smart to put a trade on in the direction of the trend (stocks tend to move in the direction of strength), you want to watch for weaknesses in the trend.

Feel free to play with other lengths of moving averages. EMAs (or exponential moving averages) often aid in short term trend direction. They react to the underlying prices faster, although, that can lead to whipsaws. The smart thing to do is practice and experiment on your own. Having some understanding of the current trend will definitely aid you in your stock trading endeavors.

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