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How to Correctly Use Simple Moving Averages for Stock Timing

Buy Sell DecisionsOne of the biggest challenges faced by investors is figuring out when is the right time to buy or sell a stock. Most regular investors do not have sophisticated technical analysis (TA) tools to help them determine the technical health of their favorite stock. Even if TA tools like Metastock, Quotetracker or eSignal are available, the sheer number and complexity of some of the technical analysis indicators available eventually leads to some form of "analysis-paralysis". End result, not surprising that investors get distracted from the primary goal of finding the optimum entry/exit points to buy or sell their stock.

Introducing a Simple System to Identify Stock Trends

What you are about to be introduced to here is an adaptation of one of the most effective trading systems, first revealed by Dr. Alexander Elder (author of "Trading for a Living"), called the Triple Screen Trading System. Our adapted system will use Simple Moving Averages (SMAs) as part of the Triple Screen Trading System, as compared to the original which is based on either one of the following: Stochastics, MACD or RSI. The entire premise of this system is not to rely on a single indicator because no single indicator can be effective all the time. Using multiple variations of an indicator e.g. different time-frames or periods, will help create a more robust and reliable trading methodology.

How to Mitigate the Lag in Moving Averages

Simple Moving Averages (SMAs) are some of the most popular and common technical indicators used by both professional and novice traders. Moving averages are generally known to be lagging indicators and somehow, the word "simple" in SMAs seems to have negative connotations as many think that trading can never be simple. It is true that SMAs are lagging, but this does not have to be a limitation and can be mitigated. You will discover that by using multiple SMAs, the disadvantages can be overcome to keep you on the right side of the trade, most of the time. Take an example of a trader who solely uses the 200 SMA to time a stock. There will be instances where the stock will start to drop but the 200 SMA will still be pointing up. The conundrum here for most traders is whether should they hold, because the long term trend is still up, or sell because the stock is dropping. This extremely narrow usage by many traders is how SMAs get their bad reputation. Simply adding a 5 SMA, 20 SMA or 50 SMA into the equation will forewarn the trader of any potential reversal as these SMAs will react faster than the 200 SMA to any changes in price.

Why Simple Moving Averages Work, When Used Correctly

We've touched on one of the major disadvantages of SMAs and how can it be mitigated, so what then are some of its advantages. Well, the fact that SMAs are so well known that professional floor traders, hedge fund managers and even the shoe-shine boy monitor them make these TA indicators so much more powerful. The wave of buying (or selling) when a major moving average, especially the 200 SMA, is penetrated is testament to its might. Read "Does Technical Analysis Really Work" to understand the mechanism of why some technical indicators are so powerful, even though the indicator, at first glance, appears not suitable for the task at hand.

Using Multiple Time-frame MAs

So why do traders often lose when using SMAs and end up giving up on this indicator? Most novice traders generally make the mistake of using just one single SMA to make their trading decisions. This is where the chance for error is very high. Just imagine a situation where a trader buys based on the 5 SMA buy signal but does not realize that the 200 SMA is indicating a strong downtrend. The trader may get lucky and make some money, but in the long run, the prevailing long term trend will win out and counter trend trades will end up losing a trader a lot of money.

The BannRonn Trends segment of our website provides multiple SMAs of stocks in order to help you make rationale technical decisions when timing entries and exits into your favorite stock. Here are some simple rules to keep in mind when using this data:

Trading Entry/Exit Rules

AAPL Daily ChartFor Long (Buy) Positions:

  • Long term trend (200SMA) - Up
  • Medium term trend - Up
  • The final entry point will be determined by the 5 SMA or 20 SMA (depending on preference). Patience is critical at this juncture. Wait for the stock to pullback and the 5 or 20 SMA showing downtrend. Then enter when 5 or 20 SMA turns and indicates an uptrend. Stop loss point should be where the 50SMA or 200 SMA decisively show a downtrend and also depending on the individual's comfort level and risk assessment. For greater safety but with the potential risk of missing out on many good trades, the entry point can be fine-tuned to be in the vicinity of the 50 or 200 SMA.

For Short positions, just reverse the abovementioned. See the chart on the right for an example of "Buy Zones" based on the rules discussed.

Additional Tips for Successful Trades

  • Set a profit target. Many traders and investors let their profits evaporate because they don't take profits. If you believe the stock has still room to go, then at least take partial profits. Some good targets for taking profits include support & resistance areas near Pivot Points e.g. Weekly Pivot, R1, R2, S1, S2. You can see an example at the support and resistance page for Apple Inc. Many a time, a nimble trader is able to re-enter at a much more favorable price after exiting near a pivot point.
  • Don't get married to a stock. There are virtually thousands of stocks out there in various sectors and industries. If a stock does not meet your criteria, find another one. If you buy into a stock and so happens that it turns south immediately, with all the indicators also reversing, it's best to cut your losses and move on to the next target.
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