Often, when people first became interested in the stock market, they develop an interest in technical analysis. But sometimes, after reading a book or two on the subject, they find they know no more than before they read the book. Discouraged, many people give up.
But there’s no need to. When something looks complicated the best place to start is with something simple. And in technical analysis that means starting with moving averages.
Even though they’re simple and easy to understand, moving averages can be an important tool in a trader’s toolbox. Let’s have a quick look at how they work…
A moving average is simply a rolling indicator many traders use. It can help eliminate some of the market noise. And it’s helpful to detect ‘trends’ arising in a stock.
So for example, a 10-day moving average (MA) is the average price for the past ten days. Or, a 200-day MA is the average price for the past 200 days. See, simple. Generally, a trader will use two or three moving averages of different durations to define a trend.
How does that work? Again, it’s simple. When these indicators cross over, it’s often a signal of a change in market direction.
Look at the example below:
Here, it’s showing a 15-day MA crossing through a 50-day MA. A trader might interpret that as ‘upward momentum’.
Simply put, it’s showing you this stock is moving higher.
Using a Moving Average In A Real Trade
Our own Murray Dawes, editor of Slipstream Trader, uses these simple indicators to track trends and changes in shares. In fact, he says it plays a key role in determining his stock picks for
Slipstream Trader subscribers.
Normally we would show you an example of a past trade, but today we wanted to show you how Murray applied his analysis to a live trade in the Slipstream Trader portfolio. Of course, we can’t reveal the name of the stock, so we’ll have to call it ‘Stock A’.
What we can tell you though, are the reasons behind the trade, and the outcome he’s expecting.
In the middle of May (the month of market carnage) Murray was sure there was still, ‘plenty of downside to come.’ Essentially he felt the markets had further to fall.
Since Murray opened the ‘Stock A’ trade, the ASX200 has fallen 5.5%.
So what made Murray want to short sell this share?
‘ XXXXX retested the 35-day Moving Average’, Murray tells me, ‘and then it headed back down below the 10 day MA which places it in an intermediate downtrend.’
Have a look at the chart below…
When Murray says the stock retested the 35-day MA (red line), he means ‘Stock A’ didn’t go above this price level. And because the 10-day MA (blue line) remained below the 35-day MA, this suggested the stock price was set to fall.
And fall it did! In less than a week, Murray told his subscribers to take what he calls a ‘Phase 1 profit’. That means they should close a portion of the trade to take a profit.
It’s part of Murray’s risk management strategy. Lock in profits where you can. He suggests doing this in case the share price changes direction. It eliminates some of the risk when trading.
As Murray tells me:
‘There is a reason I took profit initially. Since XXXXX fell over that first week, we’ve had to wear a month of nowhere trading. XXXXX rallied very close to our entry price. If we didn’t take profit we would have felt under pressure on the trade and may have made a risky decision to close out the trade early.
‘Because we took some early profits, we could ride out the past few weeks of XXXXX going nowhere. Now the price is falling again.
‘What I’m looking for now is a failure below that 200-day MA. Should fall below this level we could see a new low. This is good for us. We are not under pressure right now, which means we can sit back watch this trade evolve.’
Trading Stock A
This is only a small part of Murray’s technical analysis. Murray actually uses his own proprietary technique. But when the moving averages confirm other technical set up he uses, his conviction increases.
And after the Dow Jones Industrial Average fell 250 points on Thursday night, we asked Murray if the market was set to drop further.
He said, ‘Thursday night was just a tip-toe through the tulips.’
We think he means you should prepare for more market mayhem!
Look out for more analysis in your inbox from Murray over the next few days.
Editor, Money Weekend
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