Don Vito Corleone pulled Sonny aside, put his arm around him and said:
"Never let emotions cloud your judgment."
While the Don was referring to Sonny's hot-headed nature during a much more grave matter than what I'm applying it to, the message is the same when it comes to investing. Never let emotions cloud your judgment while you're trading.
Today I'm going to show you how to use moving averages to help you take emotions out of your investing, so you can make level-headed decisions about your stock trades. There are three ways in which moving averages can give you unbiased, emotionless opinions on your favorite stocks.
What Exactly is a Moving Average?
A moving average is nothing more than the average of a stock's closing price over a specified amount of time. The most commonly used moving averages calculate price over periods of 50, 100, and 200 days. They are plotted on charts as lines that follow the price action.
The mathematics behind the moving average helps investors determine the trend of a stock. I'm sure you've heard the term "The trend is your friend." Well if the trend is your friend, then moving averages are the best way to help you figure out who your friends really are.
Determining the Trend
Think for a second about what a moving average is telling you. Let's use a 50-day moving average as an example. If the stock price is above the 50-day moving average than the current price is higher than the level where the stock has been trading on average for the last 50 days. If a stock is trading higher than it has been in the past, then it must be trending higher currently. Should the stock continue to trend higher, it will stay above the average of the last 50 days.
So the easiest way to determine what the trend is on a specific stock is to compare it to a moving average. Stock prices above the average are in an uptrend, while stock prices below are in a downtrend. It may sound like an oversimplification, but you are actually completely removing emotion from the equation and giving yourself a totally unbiased view of the situation.
More . . .
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Overbought and Oversold Stocks
Not only can we easily tell whether or not a stock is in an uptrend using this simple device, but the moving average can also help us recognize just how overbought or oversold a stock is. You can figure this out by seeing how far away from the moving average a stock's price is.
If a stock is far above its 50-day moving average then it's likely overbought, at least in the short term. On the flip side if a stock is far below the 50-day, then it's likely oversold in the short term. Reversion to the mean is the mathematical explanation for this assessment. Prices have a tendency to revert to historical norms over time. Using moving averages can help you recognize what that historical norm is and how far the current price is away from it.
Triggers for Entry
By using two different moving averages you can take the guess work out of figuring out the best time to buy and sell. The interaction between moving averages can act as a trigger which gives you "Buy" and "Sell" signals.
The most common practice involves a short term and long term average. When the shorter term average crosses over the longer term average, the market is telling you something. Mathematically it's saying that recent price action is moving in a direction more aggressively recently than it has been in the past. In other words, a fast average crossing over a slow average tells you price is on the move now. This can help you keep your finger on the pulse of the market.
What You Can Do Today
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Good Investing,
David
David Bartosiak is Zacks' resident technical and momentum expert. He selects stocks and delivers daily commentary for our Momentum Trader.
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Zacks Investment Research