Stock Options Trading
and Technical Analysis Basics

Moving Averages

Moving averages are among the most simple technical indicators available. They are used to smooth the price pattern of the stock, and provide an easy-to-see indication whether the stock is currently trending (moving up or down) or in a trading range (moving sideways).

As the name implies, moving averages are based on the averages of the stock's price (most commonly its closing price).

A 20-day average will take the average of the stock's closing price for the 20 most recent trading days. The next day, the new day's stock price will be added to the average, and the oldest price of the previous 20 days will be taken out. This will create a slowly-moving trend of the stock's price, in this case a 20-day moving average, as seen in the chart below.

Click here to view a larger updated version of the chart at Stockcharts.com

As seen above, the actual price pattern of the stock is very volatile, with a single day's price changing by over $3. However, once we apply a 20-day indicator to it, the pattern is smoothed, and we can see a trend develop. As can be seen in early February, even though the stock's price jumped more than $5, the moving average did not change much, since it took into account the last 20 days worth of data, and smoothed the trendline.

For example, in mid February, just looking at the stock's price pattern, it seemed that the stock had stopped its upwards trend and was beginning to go down. However, the moving averages indicated that the stock was still in a strong uptrend which would continue till early March. Heeding the moving averages would have kept investors in the stock during the rally in late February.

Likewise, the spike in the stock price in late May and early June might have tempted investors to buy into the stock again. However, the moving averages told a different story. The moving average was flat and indicated that an uptrend had not developed. True enough, the stock started trading downwards from early June right into July.

Easy-speak Moving averages are one of the most simple technical indicators. It is based on the average of a stock's closing price. It is used to smooth the price pattern and show whether the stock is trending upwards or downwards.

What we covered above are called Simple Moving Averages, or just Moving Averages. Another form of averaging is known as Exponential Moving Averages or EMA for short .

In simple moving averages, say a 20-Day moving average, each of the 20 days' prices have equal weight in calculating the average. However, in exponential moving averages, the most recent prices have more weight than the earliest ones.

As such, during a surprise rally, the exponential moving average will respond faster and start to trend upwards earlier. Take the chart below for example. The simple moving average is marked in blue, and the exponential moving average is marked in red.

In late May, there was a sudden surge in RYL's stock price. The exponential moving average, being more sensitive, reacted quickly and started trending upwards. On the other hand, the simple moving average still took into account the previous down days, and did not even register an upward trend till the rally was almost over!

Click here to view a larger updated version of the chart at Stockcharts.com

So which type of moving average is better?

Both have their own merit. The simple moving average is less prone to whipsaws and false alarms, and will only indicate trends when the price pattern is more pronounced, while the exponential moving average might register false alarms.

On the other hand, exponential moving averages are more sensitive to sudden price changes and are able to react faster. Since we are dealing with option trading, we would tend to follow the exponential moving averages, since their sensitivity and quick movement are ideal for the short-term and volatile nature of option trading.

Easy-speak Exponential Moving Averages give more weight to the most recent data, and are therefore more sensitive and can react better to sudden price changes. This makes them more suitable for option trading.

So, how do we use moving averages?

As has beem mentioned, both simple and exponential moving averages are primarily meant to indicate whether the stock is in an uptrend, downtrend or sideways trading range. This can help prevent investors from buying into a stock that is stuck in a trading range or starting to trend downwards.

Another common way of using both simple and exponential moving averages is by noticing when the stock price crosses above or below the moving average. This shows that the trend (either up or down) has reversed, and a new trend is developing.

Looking at the RYL chart above, the stock price crossed upwards from below the exponential moving average in late Februrary and late May, indicating that investors are starting to buy the stock and the trend is moving upwards. These would be good times to buy call options or any bullish option strategy on the stock.

Conversely, at the end of March and early July, the stock price crossed below the exponential moving average, indicating that it was time to implement bearish option strategies.

Easy-speak When the stock price crosses above the moving average from below, it is time for bullish strategies. When the price crosses below the moving average from above, it is time for bearish strategies.

However, it can be seen that the stock price crossed the exponential moving average many times in those 6 months, creating a lot of false alarms. Heeding every crossover would have been a very painful and costly experience.

The reason for that is that a 20-Day exponential moving average is probably too sensitive and erratic. The moving average can be modified to accomodate different periods or date ranges. For example, the chart below presents both the 20-Day (in blue) and 50-Day exponential moving averages for CAT.

Click here to view a larger updated version of the chart at Stockcharts.com

As can be seen, the 50-Day exponential moving average (in red) is much smoother than the 20-Day, and therefore can indicate trends better. In addition, the stock price crosses it less often, producing less false signals.

However, by the time the stock price crosses the 50-Day exponential moving average, the rally or crash is almost over. In other words, the longer the period being averaged, the less sensitive it is, and the slower it is to react.

So what period moving averages should we choose? This depends on the individual's risk profile and investment strategies. Someone with a low risk profile and long-term strategies might choose slower moving averages, while someone willing to risk more might go for faster moving averages. The most common ones are 20-Day, 50-Day and 200-Day simple and exponential moving averages; for short-term to long-term strategies, in that order.

Since most option strategies are volatile and short-term in nature, shorter moving averages (though more risky with more false alarms) are needed to "catch the wave". Some options investors compromise by using a slightly slower moving average such as the 24-Day and 30-Day averages.

Please be reminded that this indicator should not be used on its own, but rather with one or two additional indicators, in order to confirm any signals.

Easy-speak Different periods can be used for moving averages. The longer the period, the more confirmed the trend, but the less sensitive it is to sudden price movements.

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