The Trend Is Your Friend - Moving Averages

WALL STREET SMARTS, THE BLOG, IS NOW WALL STREET SMARTS, THE BOOK.  FULLY EDITED AND REVISED WITH NEW MATERIAL ON AMAZON

Warren Buffett said that once he had purchased a stock, he could forget about the market and its gyrations.  Al Frank had the following to say in his classic, Al Frank's New Prudent Speculator:

Still, we do know that markets have fluctuating periods of advancing and declining cycles.  Markets become overvalued from time to time and thereafter decline, after which they become undervalued and subsequently advance.  Markets alternate: they become overbought, and thereafter sell off, after which they become oversold - which lays the foundation for the next rally.  These swings from overbought and overvalued to oversold and undervalued are not neat, nor are the turning points easily predictable, if at all.  Market movements are further complicated by the nature of short-term, intermediate-term, and long-term "trends", which sometimes yield conflicting current readings

When technical investors are poring over their charts, what are they looking for?  There are any number of signs to be divined by the chartists, but discovering the overall trend of a stock or a market is one of the most popular.  Studying moving averages is one of the most basic exercises of the technical analyst.  A moving average ("M/A") provides the price history of a stock or a market. Each analyst has his or her favorite time period for looking back.  The speculator or trader looking at an individual stock will create a chart showing an M/A for the stock over a set time frame.  One of the most basic of these is the 10 day M/A for a stock.

We will create a 10 day M/A for an individual stock since it is easily calculated.  It helps to have graph paper on which you can create a vertical line of price numbers and a horizontal time line.  Since you are calculating a number which is the average price of a stock over a given 10 day period, your graph will show only that one number (the average price) for the 10 days going backwards (the chosen time frame).  For our example, you will keep track of a stock's price over 10 consecutive days.  When you have prices for 10 days, add the prices up and divide by 10, which gives you your first average.  Note that on your graph.  Each day thereafter, you drop the price of the stock 11 days ago and add in the latest price.  You then recalculate the average for the new 10 day period and plot it on your graph.  Over time, as you do your daily calculations and add the results to the graph, you will start to see one of three trends:  the stock is going up, down or remaining unchanged.  Technical analysis holds that each of these trends can provide insight into where the stock price may be headed in the future.

Since you are creating your own chart, you can pick any time line for your average: 5, 10, 30, 45, 60 or 200 days or any other number of days of prices.  It is a personal decision as to how many days to use in creating your M/A.  Regardless of the number of days used, the exercise is the same.  You drop the oldest price, add the newest and average them.  There is a very good explanation of time periods to use when creating your own M/A on the website, Trading Plan.com.  It provides guidance on tailoring your graph to your investment horizon, which is the time period over which you expect to hold your investment.  If you will be speculating over the long term, an M/A of 200 days may be what you want.  It would be of little value if you are trading on a daily basis since it will not provide the immediacy you need.  Conversely, if you intend to trade or speculate over an intermediate period of time (45-60 days), a 10 day M/A does not give you the longer term chart your investment strategy may need.  

If the analyst is looking at an entire market, he or she looks to the Advance/Decline Line ("A/D Line"), which is the ratio of the number of stocks in the market going up compared with the number of stocks going down over a prescribed period of time.  If there are more stocks rising than falling, then the A/D Line is telling the chartist that the market is on the rise.  If the declines exceed the advances, the chart is indicating future declines.  We will be looking at the A/D Line in greater depth in a future blog.

You will note that I use the words "speculator" and "trader" in this blog; not "investor."  This is intentional, since, as I said in an earlier blog, technical analysis lends itself to short or intermediate periods of holding a stock.  For the long term value investor, market moves are seen as less important.

The material from Al Frank's New Prudent Speculator by Al Frank, copyright 1995 by Al Frank, is used with permission of the copyright holders, the heirs of Al Frank.

Comments are always welcome.