Last month I wrote about technical analysis and why charting does work.
To continue this discussion, I want to focus on moving averages as a technical indicator.
Technical analysis is based on three assumptions:
So do technical indicators work?
Looking at the last five years on the Australian sharemarket from 23 March 2006 to 23 March 2011, there are definitely some technical indicators that, had you used them, would have delivered a significant upper hand to help you outperform the market.
Think about this. If you took a buy and hold strategy with the ASX 200 over those five years, you would have seen a negative 5% return. In contrast, if you took a strategy using the 50 day moving average you would have seen a return of 37.2%. Even better, if you paid attention to the signals from the 50 day exponential moving average, the return would have been 60.7%.
Pretty compelling, right? So, how to you use these technical indicators?
When you consider the technical indicator of a simple moving average, you will see share prices smoothed out. Moving average charts will show you the average price of an index or stock over different periods of time. For example, a 50 day moving average is the average price of a stock over 50 days.
Moving averages are called lagging indicators because while they can give signals that a trend has started or ended, they give this signal after the trend has already started. That is why they're called a trend-following indicator.
Like all technical indicators, using a moving average to trade is no guarantee to make money. Technical analysis is all about the probabilities and trends. A moving average simply helps you identify those trends.
And the great thing is, you never have to calculate the moving average yourself — it’s provided for free at Bell Direct – just log in and go to ‘Research & tools > Advanced charting’, then choose the ‘Indicator’ tab and select 'Moving average' from the drop-down list.
The chart below shows BHP over one year with a 50 day moving average:
When you apply the simple moving average line to a share, and you see where it crosses the price line, that indicates a buy or sell signal.
A common sharetrading method is to buy when the moving average line breaks above the price line. Once the moving average line breaks below the price line, then it gives you a signal to sell and 'go short' (going short means profiting from a decline in share price).
In other words, taking a short position means taking a position which allows you to profit from a downward movement.
Most investors buy stock hoping it will go up, which is 'going long'.
An exponential moving average (EMA) is similar to the simple moving average except it puts more weight on recent price action. This reduces the lag which comes from the simple moving average.
The reduction in lag also usually provides a better profit result.
So if we look at that period between 23/3/06 and 23/3/11 for the Australian sharemarket, the EMA returned 60.7% compared with the SMA return of 37.2%. It certainly outperformed the buy and hold strategy return of negative 5%.
You can see from the graph below (this time using WebIRESS), which shows the ASX 200 from September 2010 to April 2011, that I've highlighted the buy and sell signals commonly used with the 50 day exponential moving average.
Some traders will wait 1% above or below the break signals to increase the probability of success.
Remember, moving averages can be used to identify trends and work well in an up-trending or down-trending market. However, they usually aren’t effective in a sideways market.
In a sideways market you will tend to get whiplash, which is when there are buy and sell signals around the same price.
Happy trading!
Julia Lee Equities Analyst Bell Direct Have you started trading with Bell Direct for just $15 a trade? Register now for free.