09 Nov 2017 Moving Averages
Using moving averages can be very helpful to investors to time purchases and sales. It also helps to smooth daily volatility.
What is a moving average?
Adding the latest day’s price and subtracting the first day’s price of the chosen period to calculate the simple moving average. Example: The value of today’s 5 day moving average for a share is calculated by adding today’s price and subtracting the price 6 days ago. The average of the last 5 days is therefore taken.
Moving averages can be used in a number of ways to time a purchase or sale without any fundamental analysis of the market.
- An investor can wait until a selected long term moving average turns upwards before buying or downward before selling.
- Wait for the share price to rise upward through the moving average before buying or for the share price to fall through the moving average before selling.
- Only purchase if the share price rises through the moving average while the moving average itself is trending up. If the moving average itself is trending down, it can be construed as a short-term correction in a bear market and indicate a selling opportunity. The converse is true for a falling share price.
- Investors can use a shorter dated moving average and a longer dated moving average. Whenever the shorter dated moving average crosses the longer dated one upwards, buy; and sell if the opposite happens. Investors can also use more than two moving averages. This is the most frequently used.
Choosing the right term for a moving average is of utmost importance. Some expensive charting packages provide moving average “optimisers” that will determine the most profitable moving averages for the period selected, like Bloomberg. But even without that tool investors can select profitable moving averages. The basic principle is that a moving average should provide as early a warning signal as possible of a change in the trend with as few false signals as possible. There is no specific moving average that can be applied for all shares and the same moving average cannot even be applied to the same share in all periods. My advice is to play around with different moving average periods until you find an early warning with few false breakouts. This is of course much easier in a trending market than a market that moves sideways.
Moving averages help a trader and investor to follow one of the golden rules of investing namely: cut your losses and ride your profits. Trusting moving averages helps to ride with the trend because you don’t have to make the selling decision; the charts make that decision for you.
Example – Naspers:
Moving averages work better in trending markets than sideways markets as can be seen in this example of Naspers. I played around the moving averages to get the best fit and decided on the 15 day MA and the 30 day MA. Whenever the 15 day crosses the 30 day downwards I would sell or go short. Whenever it crosses upward I would buy or go long. An excellent sell signal was given on 29 September 2016 at R2,420. On 9 January 2017 a buy signal was given at R2,124. In February and March a false sell and buy signal would have resulted in a small loss to get back in. In June and July a small loss would again have occurred when Naspers started a quick recovery. However, buying Naspers at R2,750 would have resulted in a profit of 27% per share when it reached R3,480 on 1 November.