Here’s an easy way in which the moving average can be applied:
The moving average can be used to identify potential trading opportunities. When the stock price trades above its average, it suggests that traders are confident in the potential for prices to rise – indicating a potential buying opportunity.
When the stock price trades below its average, it suggests that traders are pessimistic about where the price is going and that there may be selling opportunities.
We can create a straightforward trading system from these results. It involves setting certain criteria to pinpoint when to enter and exit a trade.
Let’s define a trading system based on a 50-day exponential moving average. Essentially, an effective trading system provides you with an indication to initiate and execute a trade, so let us look at the rules for this specific approach:
When the current market price is greater than the 50 days EMA, invest in it and stay invested until necessary sell criteria are met.
Close any long positions once the current market price is lower than the 50-day exponential moving average.
This chart features the application of the trading system on GNA Axles, indicated by the black line, which is a 50-day exponential moving average.
Beginning on the left, B1@165 is marked on the charts as the first chance to purchase. Here, we can see that the stock price has gone above its 50 days EMA, so in accordance with our trading system’s regulations, we initiate a new long position.
We kept our position until we got an exit signal at 187 (S1@187), resulting in a profit of Rs.22 per share.
The subsequent signal to buy was at B2@178, and the next to sell was S2@182. Though this proved profitable, with a gain of Rs.4, the most impressive trade was B3@165 and S3@215, resulting in a Rs.50 gain.
Here is a brief overview of how the trading system performed in these trades.
It is clear that the first and last trades yielded a profit, while the 2nd trade was less successful. Upon further examination, it appears that the stock was trending during the 1st and 3rd trade but moved horizontally during the 2nd.
This brings us to an important conclusion about moving averages: they work best when a trend is present and are not as effective in relatively flat markets. In other words, the ‘Moving average’ is essentially a trend-following system.
In the course of my trading career, I have observed a few essential properties of moving averages. Through firsthand experience, it is clear that they can provide efficient support in forecasting future trends and help identify buy and sell points.
BPCL is another case where the MA system proposed multiple trades during a period of sideways movement. Unluckily, none of these turned out to gain any advantage. Fortunately, the final transaction produced an impressive 67% return over a period of 5 months.