Best Guide to Moving Averages and MACD | 2024 Edition

Last updated on September 4th, 2024 at 10:19 am

What is a Moving Average ?

Imagine you’re a teacher and you want to see how a student is doing over time. Instead of looking at just one test score, you look at their average scores over several tests to see if they’re improving or getting worse. That’s what a moving average does but for stock prices. It helps you see trends by averaging prices over different periods.

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How Does It Work ?

Let’s say you’re tracking the number of jellybeans in your jar each day for 10 days. To spot a trend, you can average the number of jellybeans over a smaller time frame, like 3 days at a time, and see how the average changes.

For example:

Day 1-3: Average of jellybeans (let’s say 5, 6, 7 jellybeans) = 6

Day 2-4: Average of jellybeans (6, 7, 8) = 7

Day 3-5: Average of jellybeans (7, 8, 6) = 7

This smooths out the daily fluctuations and helps you see if the number of jellybeans is generally going up or down.

Types of Moving Averages

15-Day Moving Average: Looks at the average jellybeans over the last 15 days.

50-Day Moving Average: Averages jellybeans over the last 50 days.

200-Day Moving Average: Averages jellybeans over the last 200 days.

In stock terms, these are used to see long-term trends. Short-term moving averages react faster to price changes, while long-term ones show more overall trends.

Moving averages help you make sense of the stock market’s ups and downs by smoothing out short-term noise. It’s like watching a smooth video of jellybean growth instead of just seeing the daily bounces.

Related Indicator: MACD

Imagine the MACD (Moving Average Convergence Divergence) as a super-duper jellybean tracker. It compares two moving averages to see if they are getting closer together or moving apart, helping you figure out if the trend might be changing.

MACD: If the jellybean averages are crossing each other or diverging, it might mean a big change is coming.

In summary, a moving average is like averaging your jellybean counts to spot trends, helping you understand whether your jellybean supply is growing or shrinking over time. It’s a handy tool for traders to spot stock trends and make decisions.

Let’s break down the two main types of moving averages with a simple and fun analogy!

Simple Moving Average (SMA)

Imagine you’re baking cookies. Each day, you write down how many cookies you bake. If you want to see your average cookie-baking performance over a week, you add up the number of cookies baked each day and then divide by the number of days.

For example:

Day 1: 10 cookies

Day 2: 15 cookies

Day 3: 12 cookies

Day 4: 14 cookies

Day 5: 16 cookies

To find the Simple Moving Average over these 5 days:

Add the cookies: 10 + 15 + 12 + 14 + 16 = 67

Divide by the number of days: 67 / 5 = 13.4

So, the SMA is 13.4 cookies per day. The SMA treats each day’s cookie count equally, just like treating each stock price equally in the calculation.

Exponential Moving Average (EMA)

Now, imagine you’re making a special batch of cookies, and you think that cookies baked more recently are more important. You decide that cookies from today should count more towards your average than cookies from a few days ago.

To calculate the Exponential Moving Average:

Give more weight to recent days. For example, today’s cookies might count for 50% of the average, yesterday’s 30%, and the day before that 20%.

Calculate the weighted average. This means today’s cookie count impacts the average more than the older days’ counts.

So, if you baked 20 cookies today, 15 yesterday, and 10 the day before, the EMA will show a higher weight for today’s cookies and reflect that more in the average.

In short, SMA (Simple Moving Average) is like averaging cookie counts by treating each day equally. It’s straightforward and easy to calculate.

EMA (Exponential Moving Average) gives more importance to the latest cookie counts (or stock prices). It’s more complex but provides a more responsive measure that reacts faster to recent changes.

So, in the stock market, SMA gives you a basic, equally weighted view of price trends, while EMA focuses more on recent prices, making it more sensitive to recent movements.

How to use moving averages with a fun and simple example!

Understanding Moving Averages

Think of moving averages like tracking the popularity of a trending song. You check how many times it’s played each day to see if it’s becoming a hit. The moving average helps you see the trend by smoothing out the daily ups and downs.

Points to Note:

Lagging Indicator:

Imagine you’re looking at yesterday’s weather to figure out today’s outfit. A moving average is like that—it’s based on past prices, so it doesn’t predict future movements but helps you understand past trends.

A 200-day moving average (200-DMA) is like looking at weather patterns from the last 200 days. It tells you about long-term trends but reacts slowly to recent changes.

A 20-day moving average (20-DMA) is like looking at the weather from the last 20 days. It’s quicker to show recent trends but less about the long-term.

Customisable Length:

You can set the moving average for any period, like choosing how many days you want to track the song’s popularity. Shorter periods (like 20 days) are more sensitive and react quickly to recent changes. Longer periods (like 200 days) are smoother and show broader trends but are slower to react.

How to Use Moving Averages:

Combine Different Periods:

Mix and match: Use both short-period and long-period moving averages. For example, you might track a 20-day moving average to catch quick changes and a 200-day moving average to see the overall trend. It’s like having both daily and yearly charts to track your song’s popularity.

Experiment with Periods:

Try different lengths: Experiment with various moving average periods to see what works best for you. Just like trying different radio stations to find the best music, experimenting helps you find what suits your trading style.

Watch the Direction:

Rising Moving Average: If the average is going up, it’s like your song is climbing the charts—prices are trending upward.

Falling Moving Average: If the average is going down, it’s like the song is losing popularity—prices are trending downward.

Summary

Lagging Indicator: Moving averages show past trends, not future predictions.

Customisable: You can choose how long to track, from short periods for quick updates to long periods for broader trends.

Combine and Experiment: Use different moving averages together and try different lengths to find what works best.

Direction Matters: Look at whether the moving average is rising or falling to understand the trend.

In essence, moving averages help smooth out the noisy data to show clearer trends, just like tracking a song’s popularity helps you see its rise or fall on the charts.

Moving averages to spot stock trends with an easy example:

Spotting Trends with Moving Averages

Imagine you’re looking at a see-saw (teeter-totter) in a playground. The see-saw’s movement can help you understand how the stock price behaves with respect to its moving average.

1. Uptrend: Moving Average as Support

Picture this:

You’re on a see-saw that’s tilting up, and you’re sitting on one side while a friend is on the other side. As long as the see-saw is going up, you’re on a steady support (the see-saw’s board) that keeps you balanced.

In stock terms:

When a stock is in an uptrend, the moving average acts like the solid support of the see-saw.

Support means the stock price tends to bounce off this moving average and doesn’t usually drop below it. It’s like the floor that keeps the see-saw from falling too low.

Example: If a stock’s moving average is at $50, and the stock price keeps bouncing off this $50 level and going higher, $50 is acting as the support. The stock is likely to continue trending upward as long as it stays above this average.

2. Downtrend: Moving Average as Resistance

Picture this:

Now, imagine you’re on a see-saw that’s tilting down. You’re at the top, and as you go down, the see-saw’s board acts as a ceiling. It’s harder for you to go any higher because the see-saw’s board is pushing down.

In stock terms:

When a stock is in a downtrend, the moving average acts like a ceiling or resistance.

Resistance means the stock price tends to get pushed down when it reaches this moving average. It’s like the ceiling that keeps the see-saw from rising too high.

Example: If the moving average is at $30 and the stock price keeps hitting this $30 level and then falling, $30 is acting as resistance. The stock is likely to continue trending downward as long as it struggles to stay above this average.

Summary

Uptrend: Moving average acts as support—stock price tends to stay above it and bounce off.

Downtrend: Moving average acts as resistance—stock price struggles to rise above it.

In essence, the moving average helps you see where the stock price is likely to bounce (support) or get pushed back (resistance) as it trends up or down.

The Moving Average Convergence Divergence (MACD) with a fun and simple example!

What is the MACD?

Imagine you’re at a race between two snails: Snail A and Snail B. Each snail moves at its own pace, and you want to know when one snail overtakes the other to spot if it’s a good time to jump in and watch or leave the race.

How MACD Works:

Two Moving Averages (The Snails):

Snail A: Moves at a 12-day pace.

Snail B: Moves at a 26-day pace.

MACD Line:

The MACD Line is like the difference in speed between Snail A and Snail B. If Snail A (the 12-day EMA) is faster and overtakes Snail B (the 26-day EMA), the MACD Line shows this difference.

Signal Line:

Signal Line: Think of it as a benchmark or a judge’s decision (a 9-day EMA of the MACD Line). It’s used to determine if the race result is worth celebrating.

How to Use MACD:

Crossing the Lines:

MACD Line Crosses Above Signal Line: This is like Snail A overtaking Snail B. It’s a signal that the trend might be going up, suggesting a good time to “jump in” or buy.

MACD Line Crosses Below Signal Line: This is like Snail A falling behind Snail B. It’s a signal that the trend might be going down, suggesting a good time to “leave the race” or sell.

Visual Example:

If Snail A (12-day EMA) is ahead of Snail B (26-day EMA), and both are above the benchmark (Signal Line), it’s a sign of a positive trend. If Snail A falls behind Snail B and both are below the benchmark, it’s a sign of a negative trend.

Summary

MACD Line: Difference in speed (price) between the 12-day and 26-day EMAs.

Signal Line: Benchmark to see if the MACD Line is suggesting to buy or sell.

Buy Signal: MACD Line crosses above the Signal Line.

Sell Signal: MACD Line crosses below the Signal Line.

In short, the MACD helps you see when one trend is overtaking another, giving you hints about when to buy or sell based on the difference and crossover of these moving averages.

Crossover Trading Strategies Explained

Imagine you’re at a race between two runners: Runner A and Runner B. Runner A represents a short-term moving average, and Runner B represents a long-term moving average. Watching how these two runners cross paths helps you decide when to cheer them on or sit out.

Key Crossover Strategies:

Price Crosses the Moving Average (MA)

Picture This:

Runner A (Short-Term MA): Runs faster but for a shorter distance.

Runner B (Long-Term MA): Runs slower but for a longer distance.

When Runner A (Price) Crosses Above Runner B (Moving Average): It’s like Runner A overtaking Runner B. This could be a sign that Runner A is gaining speed and might keep going up, which suggests a buy signal.

When Runner A (Price) Crosses Below Runner B (Moving Average): It’s like Runner A falling behind Runner B. This suggests that Runner A might slow down, indicating a sell signal.

Short-Term vs. Long-Term Moving Average Crossover

Picture This:

Short-Term MA: This is like a sprinter who changes pace quickly.

Long-Term MA: This is like a marathon runner who changes pace more slowly.

Buy Signal:

When the Short-Term MA (Runner A) crosses above the Long-Term MA (Runner B), it’s a sign that the stock might be on an upward trend. Think of it as Runner A sprinting ahead and pulling ahead of the marathon runner. It’s a bullish signal (buy opportunity).

Sell Signal:

When the Short-Term MA (Runner A) crosses below the Long-Term MA (Runner B), it’s like Runner A dropping behind Runner B. This suggests that the stock might be on a downward trend. It’s a bearish signal (sell opportunity).

200-Day Moving Average Strategy

Picture This:

Imagine you’re tracking a long race with a finish line marked by the 200-day moving average.

Buy Signal:

If the stock price is above this 200-day moving average, it’s like the runner finishing the race ahead of the long-distance mark. It suggests the stock is in a strong position, indicating a buy.

Sell Signal:

If the stock price is below this 200-day moving average, it’s like the runner falling behind the long-distance mark. It suggests the stock may be struggling, indicating a sell.

Summary

Price Crosses MA: If the stock price crosses above the moving average, it’s a potential buy. If it crosses below, it’s a potential sell.

Short-Term vs. Long-Term MA: When the short-term MA crosses above the long-term MA, it’s a buy. When it crosses below, it’s a sell.

200-Day MA: If the stock price is above the 200-day MA, consider it a buy. If below, consider it a sell.

In essence, watching the crossovers of these “runners” helps you decide when to jump in or out of the race, guiding your trading decisions based on whether the stock is gaining speed or slowing down.

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