Moving averages may not be able to predict the future price of a stock, but they’re a great way to measure the current direction of prices. Moving averages are useful for determining the future prices of a stock that’s already trending up, in order to estimate future buy/sell prices. But, it’s largely useless at determining how to trade with stocks that are trending sideways.
It just isn’t capable of determining the prices of a stock that has been trading at roughly the same prices for an extended period. Another downside of the moving average is that it isn’t as responsive to market conditions. While that is very useful under certain conditions, it won’t change much if a stock suddenly rises or falls, especially when calculated over 100 or 200 days.
There are two different types of moving averages; simple moving average (SMA) and exponential moving average (EMA).
A simple moving average is very easy to calculate. For a simple moving average, you add together the closing prices for (x) amount of days, then divide it by (x), those same amount of days. That number is the SMA calculation for that day. The graph for the simple moving averages is comprised of plotting the average for each day, going back as long as you choose.
An exponential moving average is calculated differently and attempts to lag less behind the movement of the stock. An SMA does not change much from day to day with the growth or decline of a stock, so an EMA is an attempt to put more value on recent daily closing prices. An EMA is calculated by calculating the SMA first, calculating the multiplier (2/[(x)+1]), and finally calculating the EMA. It’s a bit more complicated, but it weights more recent shifts more to try and reduce the lag associated with SMA.
The lag of moving averages makes them hard to use at times for predicting trends in a stock. If a stock is staying relatively flat, moves that cross up or down the average can trigger bull or bear signals that may not be accurate. The lag of moving averages is their greatest liability and it can’t be trusted as a sole indicator of how to trade a stock. Because penny stocks trade at lower prices and therefore change more dynamically, it can be hard to predict the day to day change due to this lag.
However, moving averages can be a blessing, too. Although a stock may shift rapidly up and down, the moving average can help show if it’s generally staying within its average or making drastic moves up or down. If it’s beginning a new trend upward or downward, a shorter average (15-20) day will show greater movement than a longer average (100-200 days).
Moving averages are intended for use in stocks that are already trending in one way or the other, so they aren’t reliable with flat prices. But, both SMA and EMA can be useful in deciding how to trade stocks that are already bullish or bearish, especially when used along with technicals like MACD and Bollinger bands.
