Moving averages are one of the most popular tools for technical analysis. Before that, let's look what technical analysis is if you have no idea what it is. But if you have no idea what what stock is at all, you can read this post first: Stock Market 101. :)
What is Technical Analysis?
Generally, there are 2 types of stocks analysis method. The first one is called "Fundamental Analysis" where you analyze the stock based on the financial data (e.g. annual report). Few popular and useful methods that I mentioned in my previous post are
On the other hand, technical analysis doesn't look at the financial data at all. It analyzes the stock based on 2 things:
- Prices Move in Trends
- History Tends to Repeat Itself
It basically means that there are always 4 stages of stock cycle in any time frame as I mentioned in my previous post. Because of this 4 stages of stock cycle, technical analysis can make such prediction which cycles you're at and suggest whether you should buy or sell. Cool, isn't it?
What is Moving Average?
If you look at the technical analysis chart you always see this symbol MA, it basically means moving average. There are MA 10, MA 20, what do they mean? The number refers to days and it basically means 10-day and 20-day moving average respectively.
Let's look at the fundamental calculation for 10-day moving average (MA 10):
First Average X = (Sum of Day 1 until Day 10) / 10
The first average X is at Day 10 and look back to the past for 10 days. So it basically reflects to the past 10 days average at that point. When you join the X, Y, Z together, you will get a line and this line is called 10-day Moving Average (MA 10) "trend line". So, if the line is moving upward, it is upward trend. If the line is moving downward, it is downward trend. Simple right?
The good news is you don't need to calculate your own, most online chart (e.g. the yahoo technical analysis chart) allows you to plot the MA trend line. In general, there are 10-day, 20-day, 50-day, 100-day and 200-day moving average. It depends whether you're a short term or long term investor. For example, the larger the number (e.g. 200-day MA), it is usually used by long term investors. It also means that the longer MA will move slower than the shorter MA.
When Moving Averages Crossover...
When MA is used in pair, because of one is moving slower than another, it will have a crossover at certain point. When the fast line (shorter day MA) crosses over and above the slow line (longer day MA), it indicates a "Buy Signal" and similarly if the fast line is below the slow line, it indicates "Sell Signal".
Let's look at this example for Apple share, plotting the MA 20 versus MA 50. The MA 20 if faster line which is in green and the MA 50 is slower line in red.
- At crossover 1, MA 20 is below MA 50. Sell indicator, it tells you to sell!
- At crossover 2, MA 20 is above MA 50. Buy indicator, it tells you to buy!
- At crossover 3, Sell indicator...
- At crossover 4, Buy indicator...
You will need to look at which combinations of MA provide meaningful information to you. Basically you need to try and error for each stock because it works for one stock, it may not work for another stock.
I hope this is useful for you to understand the fundamental of technical analysis. I'm not sure how practical is this as I'm pretty new to this but I at least refer to technical analysis indicator for selling my company stock but sometimes I do not wait for the crossover to sell because I have already made enough money out of it. Sometimes, we shouldn't be too greedy especially in stock investment. :)
Some fundamental stock experts do not keen at all on technical analysis but in my opinion, I think we should look at both. Feel free to share your comment here if you have experiences on using technical analysis to make your decision in your stock investment! Do you find it useful?
[Update: April 21 2014]: Another very useful technical analysis tool that you can use is "Support & Resistance", you can find more about it here: How to Use Support & Resistance in Stock Investing?.