Overlaying the 200-Day Moving Average Line
Plotting a moving average line over the stock price chart will show the price trend in a smooth line, with fewer zigs and zags. The higher the number of days, the more long term the trend. Here's the same one-year chart for Microsoft, with its 200-day moving average line -- a commonly used long term time period -- plotted as a green line over the daily price chart. (To see a moving average line on a Yahoo! Finance stock chart, click "Technical Indicators: Simple Moving Average: Line 1 Period: [200].")
As you see, there are times when Microsoft traded above the moving average line and times when Microsoft traded below it. Institutional investors
often follow the 200-day moving average (or the "200DMA"). This indicator represents about 10 months of activity. When a stock's price is above its 200DMA, the stock is considered expensive relative to its price over that period. Conversely, when its price is below its 200DMA, the stock is seen as cheap relative to its 10-month trading activity.
One way to trade is to buy when the stock switches from trading
below its moving average and sell when it switches from trading above its moving average to when it is below its moving average.
Using that methodology for the 200-day moving average, we would have spotted a buy signal in late September and we would have ridden the stock up to its major move in November.
The 50-Day Moving Average: Fewer Days, More Trading Signals
If you want to trade over a shorter time frame, reduce the number of days in the moving average to get more buy and sell signals. Another commonly used time frame is 50 days. Here's Microsoft one-year chart with its 50-day moving average line:
In this scenario, you would have made a few trades based on 50DMA-based buy/sell signals in February, April, June, July and September:
- If you had a position in Microsoft at the beginning of the year, there was a sell signal in February, when the price moved below the 50DMA line.
- Buy in early April when Microsoft crossed from below to above its 50DMA line.
- Sell in early June, capturing a 2-point gain.
- There was also a quick buy and sell signal in July with a small loss.
- The next buy signal would have been in late September at around $29, similar to the 200DMA line, and we would still be holding it for the same gain.
The takeaway: The fewer the number of time periods, the more buy and sell signals. Use your favorite charting software/Web site to plot moving average lines with different time periods.
Stockpickr Staff
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