Spread betters are always on the look out for clear buy and sell signals. Moving averages can help.
Moving averages are simply continuous records of average price movements over time. So, for example, say the closing price for a share over five days is 20, 30, 40, 50, 60. The average is the sum of the five numbers, divided by five. Here, that's 40. Now, say on day six the price moves to 70. To get the new five-day moving average (MA) you knock off the first reading of 20, add on the new one of 70 and recalculate. The easy numbers here give you a new average of 50. So the MA trend is upward. Sure, you could have read that straight off the two sets of prices, but when markets are more volatile, MAs reveal the underlying trend more clearly than single readings. And if you can have a short term MA, then of course you can have longer ones read over, say, 50 or 200 days.
So what's the trade? Well here are two. First off, when a short-term moving average cuts up through a longer one (a golden cross), you often have a buy signal; and the reverse is true when a short-term average cuts down through a longer one (a death cross).
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Sadly, no trade is foolproof and this is no exception. One problem is that if you are following, say, the S&P 500, you may be waiting some time for a golden cross to become a death cross (almost a year in the case of the last twelve months). Another problem is that moving averages can be slow to react to extreme short-term volatility, so some traders prefer to follow an exponential moving average (EMA) these give more weight to recent prices.
Another option is to simply buy a stock when it breaks up through a moving average (say 50-day) and sell when it has cut down through it. Given recent market volatility, this is a trade that will potentially keep you much busier.
You can also use moving averages to spot resistance and support levels barriers to a further rise (resistance) or fall (support) in an asset. So, for example, if a stock has risen sharply but then starts to turn downward, some traders look for a bounce around the level of the 200-day MA. The reverse is true for a stock that has changed direction having fallen and is now heading up towards its 200-day moving average. Often these resistance and support levels will break the path of an asset, albeit not indefinitely.
Note that equity markets are far from the only places you can use moving averages they are also followed closely in the forex and commodity markets.
With both trades make sure you put in stop losses just in case your strategy backfires.
Tim graduated with a history degree from Cambridge University in 1989 and, after a year of travelling, joined the financial services firm Ernst and Young in 1990, qualifying as a chartered accountant in 1994.
He then moved into financial markets training, designing and running a variety of courses at graduate level and beyond for a range of organisations including the Securities and Investment Institute and UBS. He joined MoneyWeek in 2007.
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