Mention Two Merits Of Moving Average Method Of Determining Trend
In-depth look at the merits of using moving averages –
1. Smooths Out Price Fluctuations (Expanded):
- Dealing with Volatility: Markets are inherently volatile, with prices often subject to sudden spikes or dips due to news events, investor sentiment, or temporary imbalances. Moving averages cut through this volatility, helping to isolate the core trend amidst the chaos.
- Visual Clarity: By plotting a moving average line on a chart, it becomes visually apparent whether the general direction of the market is up, down, or sideways. This visual clarity aids in decision-making for traders and analysts, especially when compared to looking at raw, unfiltered price data.
2. Identifies Support and Resistance Levels (Expanded):
- Self-Fulfilling Prophecy: Due to their popularity, moving averages often become self-fulfilling. Many traders watch the same moving average lines (such as the popular 50-day or 200-day moving averages). If a price approaches a key moving average, those observing it are more likely to buy or sell, thus reinforcing its role as support or resistance.
- Adaptability: The support/resistance aspect of moving averages isn’t static. As the average ‘moves’ through time, these dynamic levels shift, providing insights into evolving market psychology and potential areas where trends might reverse.
Here are a few common examples of how moving averages are applied in trading and analysis:
1. Trend Confirmation:
- Crossovers: One of the most basic signals involves crossovers. When a short-term moving average (e.g., 20-day) crosses above a longer-term moving average (e.g., 50-day), this is called a “golden cross” and is often interpreted as a bullish signal. Conversely, a short-term average crossing below a longer-term average is called a “death cross” and can signify a bearish change in market sentiment.
- Slope: Traders may also assess the slope of a single moving average. Is it angled upwards (pointing towards an uptrend) or downwards (indicative of a downtrend)? Changes in the slope can act as early warning signs of a potential trend change.
2. Identifying Entry and Exit Points:
- Bounce off the Average: In an uptrend, traders might look to buy when prices briefly dip down to touch a moving average (and ‘bounce’ off it). The moving average, in this case, acts as temporary support. Alternatively, in a downtrend, bounces off the moving average could be used as short-selling opportunities.
- Trailing Stop-Losses: Some traders use moving averages to adjust their stop-loss orders dynamically. For example, in an uptrend, a trader might keep their stop-loss slightly below a moving average. As the price and moving average both rise, the stop-loss level ‘trails’ upwards, locking in profits.
Important Note: Moving averages are just one tool used by traders and analysts. It’s essential to remember:
- No single indicator works in isolation. Moving averages are often more effective when combined with other indicators or chart patterns.
- Not all moving averages are the same. Experiment with different time periods and types (simple vs. exponential) to find what suits your trading style and the asset you’re analyzing.