Moving averages are a great way to visualize a stock’s current trend and predict support and resistance for future price action. These are especially useful for penny stocks because they move based on momentum and emotion instead of fundamentals. We use mostly the 20, 50, and 200 day simple and exponential moving averages. A simple moving average is formed by computing the average price of a security over a specific number of periods. Most moving averages are based on closing prices. A 20-day simple moving average is the twenty day sum of closing prices divided by twenty. As its name implies, a moving average is an average that moves. Old data is dropped as new data comes available.
Exponential moving averages reduce the lag by applying more weight to recent prices. The weighting applied to the most recent price depends on the number of periods in the moving average.
We typically have both the 50-day EMA and SMA input on our charts along with the 20-day simple and the 200-day simple moving averages.
I want to keep this post simple and avoid getting bogged down by over analysis. The best way to use the moving averages is as a guideline for a stocks trend. Stocks tend to bounce off moving average lines. The higher the period moving average, the stronger the line typically is. For example, a stock may slide through the 20-day moving average, but bounce off the 50-day. The 200-day moving average is the strongest. Check out the FRTD chart below….
In this chart the 200-day moving average is blue and the 50-day moving average is red. You see how the stock bounced off the 50-day MA 3 times before finally falling through it. When a stock falls through a moving average line, it is bearish. When a stock breaks above a moving average line, it is bullish. You can see how the stock fell a lot further after it finally broke through that 50-day MA. The 200-day moving average did end up holding and the stock popped off it eventually.
We use moving averages as buy/sell indicators. If a stock breaks above a MA it may be a buy. If a stock breaks below a MA it may be a sell. Like any technical indicator, these patterns do not always hold true, but moving averages are some of the most consistent patters available.