I’ve heard about using moving averages to predict stock price movement. What is a moving average?

Dave B., 54, is a Hamilton technician with a low six-figure portfolio looking for aggressive growth. He asks: “I’ve heard about using moving averages to predict stock price movement. What is a moving average?”

Moving averages are one of the oldest and most useful technical indicators and can be defined as the average price of a security at a specific point in time. The purpose of a moving average is to show the trend in a smoothed fashion. For stocks, the most common time periods are 10, 30, 50, 100, and 200 days. There really isn’t just one right time frame as averages with different time spans each tell a different story. The shorter the time span, the more sensitive the moving average will be to price changes and vice versa.

Let’s look at Royal Bank stock and create a 30 day moving average.

We’ll use the daily closing price, add up the last 30 days numbers, divide by 30 and plot that point on a chart.

Then we’ll add the closing prices together for days two through 31, divide by 30 and plot that point on a chart and do the same for days three through 32 and so on. We connect all the points together in a line and run it through the closing daily price bars. This moving average shows us the smoothed price trend. A valid buy signal is given when the price crosses above the moving average if the moving average is directed upward. A sell signal is given when the price crosses below the moving average if the moving average is directed downward.

Moving averages can become more powerful when multiple moving averages are plotted on the same chart. One combination I use is to plot a 10 day moving average and a 30 day moving average. A buy signal is given when the 10 day crosses the 30 day with both averages in an upward direction and the reverse is true for a sell signal.

The average itself can act as an area of support and resistance. The more times the moving average is touched, the greater the significance of a violation. A violation of a moving average is a warning that a change in the trend is imminent. If the price crosses above a moving average, a buy signal is generated and the long position maintained as long as the price remains above the average. In a downtrend, if the price moves up to the moving average but doesn’t cross it, a sell signal is generated and short positions are held as long as the price remains below the moving average.