This article explores moving averages (MA), which may well be the oldest indicator we use. The mathematics behind moving averages and their buy and sell triggers are very easy to comprehend and recognise.
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A Case Study
The MA, regardless of the time period used in the plotting of the indicator, shows us a trend in the form of a single smooth line. Time periods will vary depending on whether the user wishes a short-term trading result or a more long-term investing perspective. The value is the next important part of the equation, and, for the most part, technicians will use the closing price of each session resulting in a simple moving average. By using an end-of-day value for a smooth MA, the average investor can take the time after the markets close in the afternoon to evaluate his or her strategy before the opening bell of the following morning.
The first chart shows the performance of Nortel Networks (NT-NYSE) starting from the first few weeks of Aug 2000 to Mar 2003. The chart displays three simple MA. The red line is a 50-day MA, the blue line is a 100-day MA and the purple line is a 200-day MA. You can see the red line is the least smooth of the three. Investors should buy an issue as the price action crosses above the simple MA and sell an issue as the price action crosses below the simple MA.
According to 50-day MA (red line) in the above chart, the best time to look at buying shares of Nortel occurred during the first week of November 2001, when the line was at about the $6.45 level.
Using the 100-day MA (blue), investors would have come back into the market on or about November 13, 2001, at the $7.50 level. And lastly, an investor using a 200-day MA (purple), for a more long-term trend approach, would not have considered buying Nortel Networks because the price action did not penetrate the MA during the short time period of bullish pricing.
For the investors who jumped into NT, the sell signals came just a few weeks after the buy signals. The first sell signal came on January 16, 2002, when the price action dropped below the 50-day MA and Nortel Networks closed at $7.27. On February 5, those investors using a 100-day MA would have received their first signal when Nortel closed at $6.20. Very little money was made by investors using these moving averages during this period of time.
It was not until the end of Oct 2002 that buy signals were once again clearly defined. On the 24th, a clear buy signal appeared for the 50-day MA proponents, who saw a closing price of $1.07, up 0.17 from the previous session. In fact, some traders may have jumped into the fray the previous day when the MA was first penetrated. The followers of the less aggressive 100-day MA had to wait until the following day when the stock price jumped again to the level of $1.14.
Now that we have had a look at a very simple approach using a number of moving averages, let's explore the importance of bringing in an additional well-known indicator that can help illustrate and confirm buy and sell signals. The volume rate-of-change (V-ROC) indicator is inserted into the above chart. This indicator plots positive values above the zero line and negative below. A positive value suggests there is enough market support to continue driving price activity in the direction of the current trend. A negative value suggests there is a lack of support and that prices may begin to become stagnant or reverse.
You can see the confirmation of the upside price trend beginning on November 5, 2001, when the volume was 13.115.400 and the V-ROC was showing a minus number (-4.52). It was exactly this day that the price action moved above the 50-day MA and the share price closed at $6.26. Two days later, as the price increased to $7.01, the trend continued and the V-ROC showed a solid positive number of 142.00 with a volume of 20,016,000.
On the November 13, the day of the second peak in the V-ROC trend, the volume was 24,956,200, the V-ROC was up again to 202.91 and the price of Nortel increased to $7.55. Finally the third peak of the illustrated trend line, which occurred on November 19, showed a V-ROC of 411.84 with a volume of 36,353,100 and a share price of $8.52. This period of 12 trading days saw a price increase of $2.26, or 36%, starting from the first noteworthy move of the price action, breaking through the 50-day MA, and giving the significant upward move of the volume rate-of-change.
The blue trend drawn November 28 to December 12 shows distinct weakness in the V-ROC as the price action continued to trade above the 50-day MA and to climb in stock price. Without the support of the V-ROC indicator showing Decemberlining volume in Nortel Networks, an investor relying solely upon the price action trading above the 50-day MA may well have lost significant gains realised over the month of March. The next major peak showing significant volume was on the downside, and the stock price fell over two dollars from the high of just three trading days previous.
Investors should take the time to confirm price trends, which can be as easy as comparing two very simple indicators that will give you good lead time and solid verification of the trend movement. Remember to check the volume and its rate of change the next time you look at a chart of your favorite moving averages.
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