How the Moving Average Helps in Technical Analysis
The moving average is a popular and important tool to help you plot moves in stock trading. Here’s a deeper look into it.
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Technical analysis is an important element of making the right stock trading decisions. Tools such as the moving average can help traders in this regard. Traders need to consider the moving average that can really help them in analysis and making important trading decisions. Moving averages have their origin in statistical analysis. They basically generate average values of various subsets of the total data set.
How the Moving Average Works Investopedia explains that a moving average smoothens the noise and disturbance caused by random outliers. It instead puts the focus on long-term trends. The moving average therefore complements any of the time series interpretations. Moving averages are used by traders and technical analysts in various kinds of tools. They have been proven to be reliable indicators.
Advantages of the Moving Average Technical analysis has its fundamental assumption that future movements can be influenced by past performance. With moving averages, you can determine past price trends. After all, securities and indexes have prices and values that are quite unpredictable and volatile. Traders are therefore always looking out for some kind of advantages that can help them reduce their risk and increase chances of profit. There are various types of moving average calculations. But all these are used for plotting a line against another indicator or a price chart. The slope and direction of the moving average lines give investors an idea of the relationship between the data values of the past and present. Concepts used in trading such as overbought, oversold, divergence, confirmation, support, resistance, etc. have their origin in the moving average analysis. Moving averages are extremely flexible, and that helps in using them to analyze the other moving averages. Analysts and chartists commonly plot two moving average lines of various time intervals, to interpret their relationship for forecasting movements in price, spotting trends and placing trades. These moving average crossovers are now therefore the focus of a full technical indicator subset. Thanks to their many advantages, moving averages have become really important for technical stock trading. They do have their shortcomings though.
Some Shortcomings It is important to remember that moving averages aren’t foolproof. The reason for that is financial markets are uncertain, and that’s felt when you use technical indicators. Investopedia reminds that it isn’t possible to always find a stock that bounces off a major average support each time it gets close.
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Investopedia points out that moving averages aren’t of much use when you have an asset trending sideways, as opposed to when you have a strong trend. Investopedia provides an example:
In this figure, you see the price of an asset passing through the moving average multiple times during a sideways moving trend. That makes the decision making process more confusing. In situations like these, you don’t always have the resistance and support of the moving average. The other drawback of using moving average is the challenge involved in making it responsive to trend changes without allowing it to be sensitive enough to cause a trader to make any premature moves in entering or exiting a position. While short-term moving averages are quite useful to identify changing trends before a large move, they could also result in traders prematurely moving in or out of a position as a result of the averages responding instantly to changing prices. The reliability of the signals depends on the time periods of the calculation. So traders would do themselves some good by referring to other technical indicators to confirm any move that the moving average has predicted. In spite of these shortcomings, moving averages are great technical analysis tools. Just ensure you’re aware of the fact that they can’t always be relied on.
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