Streetwise for Friday, February 8, 2019
Readers and students are constantly asking for some sort of an indicator from which they could discern the potential price direction of a stock or market index.
As I have pointed out repeatedly, predicting what Wall Street will do from one moment to the next is not feasible. However, if you want to have a better understanding of a trend, whether a share price or a market index, allow me to introduce you to moving averages.
A moving average analysis reveals the underlying direction and rate of change of a volatile series of numbers. And there is no better place to find an almost unlimited series of volatile numbers than those that emanate from Wall Street.
When you calculate a moving average, you are eliminating or “averaging out” short term fluctuations. It is called a “moving” average because for each period under consideration, the base with which the average is calculated, is being updated.
Many investors appear fascinated by the direction of a series of moving averages in relation to each other. The logic being that the interaction of those averages could possibly predict a trend reversal before it occurs. Or at a minimum confirm a reversal shortly after its occurrence.
While the theory might sound a bit complex, in practice moving averages are quite simple. For example, assume you wanted to compute the 200-day moving average for an index such as the S&P 500. Simply add together the index’s closing numbers for the past 200 days and divide by 200. That is a data point.
Repeat this process day or time period, only drop off the oldest number, and add in each new day’s number. Each of the resulting moving average numbers could then be plotted and compared against a graph of the stock or index itself. Naturally the calculations and plotting are left to computers.
One disadvantage of the simple moving average is that it is slow to respond to a significant and rapid change in market activity. To overcome this problem, some sort of weighting algorithm is applied that places emphasis on recent price activity.
For the most part, analysts will often utilize a 200-day moving average and interpret the results as follows:
1. If the 200-day moving average line flattens after a previous decline, or is advancing, and the stock or index line penetrates its moving average line to the upside, this is a major buy signal.
2. If the stock or index line falls below its 200-day moving average line, while the moving average line is still rising, this indicates a buying opportunity.
3. If the stock or index line is above its 200-day moving average line, but declines toward it, fails to penetrate and then moves upward, this is also a signal to buy.
4. If the 200-day moving average line flattens after a previous rise, or is declining, and the stock price or index line penetrates its moving average line to the downside, this could be a major sell sign.
5. If the stock price or index line rises above its 200-day moving average line while the moving average line is in a decline, this is also a possible sign to sell.
6. If the stock price or index line is below its 200-day moving average line, moves toward the moving average line, fails to penetrate and turns back down, consider selling.
Other types of analysis utilize both a 200-day and a 50-day moving average with the direction of the crossing points telling a story. Specifically, if the 50-day average is moving above its 200-day average, it is a bullish sign that could indicate a buying situation. However, if the 50-day average is below its 200-day average, it is a bearish sign.
Most sites, such as finance.yahoo.com that offer historical stock and index data will graph for you not only the price of a stock or index but will also offer you the ability to select and graph moving averages of your choice over the time period you designate.
To be honest, the only study I have seen that was able to show any degree of accuracy using moving averages was one that utilized 50- and 200-day averages for the S&P 500 index. So, my suggestion would be that you might want to start there. However, I always do look at a 50/200 graph for any investment.
Lauren Rudd is a financial writer and columnist. You can write to him at LVERudd@aol.com. Phone calls accepted between 9 AM and 3 PM at (941) 706-3449. For back columns please go to www.RuddReport.com.