What is moving average
Price trend of a given stock is never smooth which makes it hard to get an opinion about the approximate future direction of the price trend. And moving averages are mainly used to cope with this challenge by helping smooth out the price data. It is a commonly used technical indicator in technical analysis. Traders/Investors can use either short term or long term moving averages depending on their trading/investing interests. With the help of moving averages, negative impacts of short-term fluctuations on the price of a stock are mitigated.
When calculating the moving average, the average is taken over a specific period of time, i.e. 5, 20, 50 or 200 days. And averages do not have to be taken on daily prices, it is also common to use weekly, monthly or minute based averages as well if such forms suit better for the type of trading strategy that is executed.
It is not possible to be 100% accurate in predicting stock prices but you may make some educated guesses and moving averages are one of the common tools that are used in technical analysis when estimating the potential future direction of a stock’s price. We will look into 2 ways of using moving averages in this study.
1) Golden Cross & Death Cross
When a relatively short-term moving average crosses above a long-term moving average, it is called Golden Cross and perceived as the confirmation of an uptrend. And when the opposite happens, it is called Death Cross and perceived as a bearish signal.
As an example, traders can buy a certain stock when the 20 days moving average crosses above its 50 days moving average, and can exit from their positions when the 50 days moving average crosses below its 20 days moving average.
Even though this method may work in some cases, it may also trigger quite a number of false positive signals because moving averages are calculated based on past prices and thereby are lagging indicators. Especially in short term trading, a trading method that solely relies on Golden Cross & Death Cross signals may not always be reliable and traders tend to combine these indicators with some other technical indicators as well when making their trading decisions.
The following chart shows this approach in practice. One example is definitely not enough to generalize findings but it is a good example that illustrates why this approach can give signals with a bit of delay which may be an issue especially in short term trading. You can observe the delays in both buy and sell signal points.