Editor's note: We hope you've enjoyed our holiday series on "common sense" technical analysis. We learned why we shouldn't "fight the tape," how to safely and profitably trade market tops and bottoms, a little-known way to trade on the news, and how to track the "big money." But no series on technical analysis would be complete without today's essay...
Saturday, January 1, 2011
Before most folks even learn the difference between a stock and a bond, they hear about "bull" and "bear" markets.
A bull market is a period of rising prices. A bear market is a period of falling prices.
But how can we make a claim that an asset is in a bull market... a bear market... or somewhere in between?
This is where the concept of the moving average is useful.
The "moving average" collects a bundle of an asset's closing prices – say, each one from the past 200 days – then takes the average of those prices.
This produces a chart line that "smoothes" out market volatility so we can gauge the big-picture trend. When a market is trading above its moving average, it's in a bull trend. When a market is trading below its moving average, it's in a bear trend.
You can do the same thing with a 50-day moving average, a 20-day moving average, pretty much any timeframe you want. But the most widely used moving average on Wall Street is the 200-day moving average, a good middle-of-the-road indicator that averages the prices from about 10 months of trading.
Let me show you how it works with an example. Below, you'll find a five-year chart of crude oil...
In early 2007, the price of crude oil moved out of a sideways trading pattern and crossed above its 200-day moving average (A). It continued this price strength and climbed toward a huge top at $145 per barrel.
In mid-2008, oil had come down off its top and crossed below its 200-day moving average (B) on the way to a crushing $35 per barrel bottom.
Months later, oil moved higher yet again, crossing above its 200-day moving average in early 2009 (C) and signaling a new bull market.
Except for some "whipsaws" (D) this summer, where the trend was unclear, the 200-day moving average served as "guidepost" for gauging the big-picture trend in oil.
If you wanted to take the easy way out, all you had to do was buy oil when it crossed above its 200-day moving average and sell it when it fell back below. Though oil is only up 40% since early 2007, you would have made nearly 150%.
For the majority of traders, however, moving averages won't solely dictate buy and sell decisions. But they can serve as handy guideposts when you're studying trends.
The subject of technical analysis – also called "chart reading" – generates a lot of confusion and criticism among investors.
So we're using this week to provide Growth Stock Wire readers with a knowledge base of "common sense" ideas you can use to become a more profitable trader.
You can browse through our previous essays here: