How do moving averages help a spread better?

One of the keys to successful spread betting is to spot a trend and get in on it early. There are plenty of tools around designed to do just that. Moving averages (MA) are one of the most straightforward but also heavily used. Here's how they work and a snapshot of what they can reveal.

First off, the basics. Suppose you havefive index points for the FTSE 100 the closing prices over the previous five days. These are 5,850, 5,900, 5,920, 5,905 and 5,870. The average is 5,889 (the five added up and divided by five). Today, let's say the index closes at 5,880. The new average using the last five prices is 5,900+5,920+5,905+5,870+5,880, all divided by five, so 5,895.

The advantage of a moving average is it reveals a trend (mildly bullish, since 5,895 is above 5,889) which can be otherwise hidden by daily fluctuations. Clearly, a five-day average is quite short-term so unsurprisingly there are also 50-day and 200-day averages available for indices such as the FTSE 100 and S&P500. Once you have say a 50-day and a 200-day moving average you can start to discern turning points.

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For example, a rising 50-day moving average cutting up through a falling 200-day is often a bullish signal as, combined with, say, rising buying volume, it suggests the market is turning up. Equally, if the 50-day cuts down through a rising 200-day average it can suggest a bearish turning point has been reached.

Two moving averages can be summarised into a moving average convergence divergence number (MACD). Typically, a longer term moving average is deducted from a short term moving average to give a single figure. Again, a positive gap (so the short term average is above the long term average) can indicate a bullish turning point in a bear market, or that the security in question has been overbought short term in a bull market. If they sound like polar opposites they are! As always, interpretation is key when using any momentum indicator. For more examples, see my colleague John C Burford's spread bettingblog.