A simple application of moving average
The moving average can be used to identify buying and selling opportunities with its own merit. When the stock price trades above its average price, it means the traders are willing to buy the stock at a price higher than its average price. This means the traders are optimistic about the stock price going higher. Therefore one should look at buying opportunities.
Likewise, when the stock price trades below its average price, it means the traders are willing to sell the stock at a price lesser than its average price. This means the traders are pessimistic about the stock price movement. Therefore one should look at selling opportunities.
We can develop a simple trading system based on these conclusions. A trading system can be defined as a set of rules that help you identify entry and exit points.
We will now try and define one such trading system based on a 50-day exponential moving average. Remember a good trading system gives you a signal to enter a trade and a signal to close out the trade. We can define the moving average trading system with the following rules:
Rule 1) Buy (go long) when the current market price turns greater than the 50 days EMA. Once you go long, you should stay invested till the necessary sell condition is satisfied.
Rule 2) Exit the long position (square off) when the current market price turns lesser than the 50 days EMA.
Here is a chart that shows the application of the trading system on Ambuja cement. The black line on the price chart is the 50-day exponential moving average.
M2-Ch13-chart3
Starting from left, the first opportunity to buy originated at 165, highlighted on the charts as B1@165. Notice, at point B1, the stock price moved to a point higher than its 50 days EMA. Hence as per the trading system rule, we initiate a fresh long position.
We stay invested by the trading system till we get an exit signal, which we eventually got at 187, marked as S1@187. This trade generated a profit of Rs.22 per share.
The next signal to go long came at B2@178, followed by a signal to square off at S2@182. This trade was not as impressive as it resulted in a profit of just Rs.4. However, the last trade, B3@165, and S3@215 were quite impressive, resulting in a profit of Rs.50.
Here is a quick summary of these trades based on the trading system fared:
Sl No Buy Price Sell Price Gain/Loss % Return
01 165 187 22 13%
02 178 182 04 2.2%
03 165 215 50 30%
From the above table, it is obvious that the first and last trades were profitable, but the 2nd trade was not so profitable. If you inspect why this happened, it is evident that the stock was trending during the 1st and the 3rd trade, but during the 2nd trade, the stock moved sideways.
This leads us to a significant conclusion about the moving averages. Moving averages works brilliantly when there is a trend and fails to perform when the stock moves sideways. This basically means the ‘Moving average’ in its simplest form is a trend following system.
From my own personal experience of trading based on moving averages, I have noticed a few important characteristics:
Moving averages gives you many trading signals (buy and sell) during a sideways market. Most of these signals result in marginal profits, if not for losses
However usually one of those many trades results in a massive rally (like the B3@165 trade) leading to impressive gains
It would be tough to segregate the big winner from the many small trades
Hence the trader should not be selective in terms of selecting signals that moving average system suggest. In fact, the trader should trade all the trades that the system suggests
Remember the losses are minimized in a moving average system, but that 1 big trade is good enough to compensate for all the losses and can give you sufficient profits
The profit-making trade ensures you are in the trend as long as the trend lasts. Sometimes even upto several months. For this reason, MA can be used as a proxy for identifying long term investment ideas
The key to MA trading system is to take all the trades and not be judgmental about the signals being generated by the system.
Here is another example of BPCL, where the MA system suggested multiple trades during the sideways market; however, none of them was really profitable. However, the last trade resulted in a 67% profit in about 5 months.
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Moving averages are powerful tools for identifying trading opportunities. When a stock price trades above its moving average, it indicates trader optimism and suggests buying opportunities. Conversely, when the price falls below the moving average, it signals pessimism and potential selling opportunities. This forms the foundation of a simple yet effective trading system.
The fifty-day exponential moving average trading system follows two simple rules. Rule one: buy when the current market price moves above the fifty-day EMA and stay invested until the sell condition is met. Rule two: exit the long position when the price falls below the fifty-day EMA. Looking at the Ambuja Cement example, three trades were executed with varying results. The first and third trades were highly profitable at thirteen and thirty percent returns respectively, while the second trade yielded only two point two percent. This demonstrates that moving averages work brilliantly during trending markets but struggle in sideways movements.
Moving averages have distinct characteristics that traders must understand. As a trend-following system, they work brilliantly when stocks are trending but struggle in sideways markets. During sideways movements, the system generates many signals, most resulting in small profits or losses. However, one significant trade often emerges that compensates for all previous losses and delivers substantial profits. The key to success with moving average systems is trading discipline - taking all signals without being selective and trusting the system to deliver that one big winner.
The BPCL example perfectly illustrates the moving average system in action. During the sideways market phase, the system generated multiple trading signals, most of which resulted in small losses or marginal profits. Traders might have been tempted to abandon the system during this frustrating period. However, patience and discipline paid off when the stock finally entered a trending phase. The last trade generated an impressive sixty-seven percent profit over five months, more than compensating for all previous losses. This demonstrates why traders must take all signals and trust the system completely, as that one big winner makes the entire strategy profitable.
The key to successful moving average trading lies in understanding and following core principles. First, discipline is absolutely critical - traders must take all signals without being selective and trust the system completely. Second, understand the nature of this trend-following system: many small losses are acceptable because one big winner will pay for all of them. Third, maintain a long-term perspective, as moving averages can help identify investment ideas that last for months. Finally, the system provides excellent risk management with clear exit signals that minimize losses. Remember, patience and discipline are your greatest assets when trading with moving averages.