In our earlier Tech School, we had discussed various types of moving averages. While selecting the moving average for your analysis, it is always best to keep it as simple as possible. Hence the obvious choice is the Simple Moving Average (SMA). Due to its wide usage, predictions based on the SMA tend to get self-fulfilling.
The frequently used simple moving averages are the 10-day moving average, the 21-day moving average, the 50-day moving average and the 200-day moving average.
How to interpret SMA?
Buy signals are generated when the stock’s closing price crosses above the moving average from below after a down trend, whereas if the stock’s closing price moves below the moving average from the top after an uptrend it will be a sell signal. In Chart-1 of Bombay Dyeing, the stock price conclusively crossed over the 21-day simple moving average in mid April, indicating a buy signal.
In Chart-2 of Adlabs Film, we can observe a sell signal. The stock price closed below the 21-day moving average in mid-January 2008 conclusively (see box) indicating sell. Any trader who had acted on this sell signal and initiated a short-position at around Rs 1,400 would have made money.
Moving averages work well in trending stocks. But they are difficult to implement when the stock is moving sideways or not trending. (Refer Chart-3 of Dabur, which is consolidating sideways) So, before attempting to incorporate the moving averages the traders should first identify the stocks that show some trending characteristics.