Utilizing Moving Averages

When it comes to technical analysis, it doesn’t get much easier than drawing a trendline. But what if you’re in need of a slightly more complex indicator? The next step up from drawing trendlines is calculating moving averages. Put simply, a moving average is the average of the closing prices of a stock over a certain period of time. You can compare a closing price with a moving average to help you determine a trend.

Like most technical indicators, there are several different types of moving averages, and I explain a few in this section. First, though, it’s important that you understand how to make good choices about the time frames you use when calculating your moving averages.

Selecting appropriate moving average periods

The time frames of your moving averages are determined by the number of closing prices you include. To decide on that number, consider the types of trading decisions you make based on your moving average. Pick a time frame that’s appropriate for the amount of time you intend to have a trade on. For a trade that’s to be held for only a day or two, a five- to ten-day moving average will suffice.

For instance, the five-day example in Figure 11-3 is very short-term and is most useful for traders who trade for a day or two, or even for less than a day. I trade a system based on a moving average that uses data from only the two previous days’ closing prices. The holding period for this system is just half a day, so the short moving average ...

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