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Trading Indicators

Trading Indicators: There are a huge number of trading indicatorsonline stock trading available for online trading, and one of the problems for new online traders is deciding which ones are the most appropriate for their particular trading style and for the instrument they are trading, whether this be stock, options or currency. It is very easy to use far too many and end up with analysis paralysis!

I am in the process of developing a new site which will give an overview of all those technical indicators currently available online, and how and when to use them - this should be available shortly. In the meantime, I propose to look at one of the very simple trading indicators that I use a great deal myself - these are called simple moving averages.

Trading Indicators - Simple Moving Averages

OK - don't panic! - you don't need to work them out - remember this is the age of the internet and pc. Simple moving averages are worked out automatically by your charting package, but you do need to understand what they are and how they are calculated. Then you simply use them accordingly. Now, before I go on let me explain something else first. Simple moving averages ( or SMA's for short ) belong to a group which I call 'technical trading indicators'. All of these have one thing in common - they are all calculated using historic data, and are therefore called lagging trading indicators.

Now, you might ask why there are so many and why I am telling you about them now - firstly there are so many because over the years everyone constantly searches for the ' holy grail' of trading indicators - a technical indicator that tells you when to enter a trade and when to exit, and even more importantly, one that is always right. Sadly this has never been found, although the latest one that comes to market always promises much, only to fail later. The reason is very simple - it is easy to develop an indicator that works under certain conditions, but of course the markets do not work on mathematic analysis, nor logic, nor on historic patterns. However, some do have some merit and value and I hope the new site will help you explore these in more detail. In the meantime lets just take a look at simple moving averages.

SMA's are the most basic and simple trading indicators of all, and whilst they are a blunt tool in our toolkit, they do offer a very basic overview of what is happening on the chart - and remember being a simple soul I like simplicity! As the name suggest a simple moving average is simply that - so a 20 day SMA is simply the last 20 days prices added together and divided by 20 to arrive at an average. I did say it was simple. That's it! - I only use 2 to keep the screen uncluttered and these are a 50 day SMA  and a 200 day SMA. When you listen to commentary on the markets on stations like Bloomberg and CNBC you will hear them refer to these figures - i.e. " a commodities price has crossed below its 200 day moving average "- so even the professionals use them! OK, let's look at 2 examples. The 50 day simple moving average is red and the 200 day simple moving average is purple.

online stock tradingThe 200 day average smoothes out the data over a much longer time frame and gives you an idea of where prices are compared with the past. The points of interest to us are threefold as follows :

Firstly when prices cross the 50 day average, secondly when prices cross the 200 day average, and thirdly when the averages themselves cross. Now remember, this is a very crude tool, and is only there to give us a 'view'. It is not there to give entry or exit points, but just as a background guide, so please remember this in the following comments.

Trading Indicators: 50 Day Simple Moving Average

This gives us a close up view of how prices compare over the last 50 days. Each day is added on to the last so it is always the most recent set of 50 days which are averaged. As you can see as prices move up they tend to touch the 50 day SMA - always a good sign. Why they do this is not clear, but it happens regularly. When the prices cross the 50 day average then we should pay attention. Now it may only be a temporary blip ,as in this case, but it could be the signal for a change - so it is an early warning to us to pay attention!

Trading Indicators: 200 Day Simple Moving Average

The 200 day average is over a much longer timescale, so by the time prices cross this average, we should either have been stopped out or closed out our position. The average smoothes out the data over a long period, and the reason you will hear it mentioned in the media, is that it can and does indicate a significant change in sentiment - but remember it is only there as a guide - not a signal. If prices cross the 200 day SMA and you are still holding a position - be careful!

Trading Indicators: Crossover of the SMA's

The only other significant point is where the two averages cross one another. The crossover point can represent the change in sentiment from rising prices to falling prices, but be careful - when you watch these averages they will cross over and return on their original path, so they are not a reliable indicator and remember also they are lagging. So treat them purely as a rough guide to what is happening - not a hard and fast rule. They are there to give an early warning to pay attention - nothing else!! Now, you would couple the above with your chart reading skills - what do you see to confirm that this is not good news ??? Just after the crossover we have a hanging man and an upthrust, a classic sign of weakness. This is followed several bars later by another big upthrust, which would tend to confirm crossover. Use your candle and volume analysis skills to confirm what you see with the SMA's - NOT THE OTHER WAY ROUND!

online stock chartOK - the last example is as shown alongside. The 50 day SMA crosses the 200 day and is now below the 200 day SMA. As prices continue on down the tops of the candles now touch the 50 day SMA as they move down. ( this is the reverse of the first example where the bottoms of the candles were touching it as it was below them ) This continues for some time, until we get a downthrust at the bottom, prices cross first the 50 day, then the 200 day, and eventually the two averages cross over again and the trend is reversed. My final word is this - use simple moving averages as a simple early warning systems of possible future changes in direction. Read them in conjunction with your candlesticks and volume interpretation to see if the alarm can be validated by your analysis from the chart readings. Do not use them in isolation, or try to use them as some sort of indicator - you will fail! They are a rough guide ONLY - no more no less. Remember, simple moving averages are a lagging trading indicators as indeed are most technical indicators, but they will be a key part of your online trading success

Now we are going to look at Money Management - the single most important part of trading.

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