Moving averages

The moving average indicator for a given security is, as its name implies, the average of past stock prices (the closes). The period (10, 20, 50 days, etc) indicates how many days the moving average looks back. There are different types of moving averages: simple (SMA), weighted (WMA), exponential (EMA=), etc. The important thing about moving averages is that they smooth out the stock prices and that they are always lagging.

When the stock is in an established uptrend, the price is above the moving average (most of the time). This is due to the fact that the MA averages past prices: when you average prices that go up to the current day's price, you are going to get a lower price than the current day's price. In a downtrend, it's the exact opposite as the price is under its moving average.

It is fair to say that when the price crosses the moving average to the upside, the stock is trending up and the crossover is an excellent entry point for a long trade. When the price crosses the moving average again (to the downside), this is a signal to exit the position. The price/moving average crossover method is a reasonable trade decision tool but it may suffer from whipsaws when the price briefly goes below the average signaling a "false" reversal.

To eliminate the whipsaw effect, two moving averages (one fast and one slow) are considered. In an uptrend, the faster (short-term) moving average rides above the slower (long-term) one. In a downtrend, it's the opposite. If you want to use this two moving average trade decision tool, you enter a long trade when the faster moving average crosses over the slower one and you sell when the faster moving average dips below the slower one. Because the moving averages are always lagging, the exit signal usually occurs when the stock price has already dipped past the top of the uptrend. The same process applies to shorting a stock but you obviously have to consider the opposite signals.