Combining two moving averages

Comparing closing prices with moving averages is a great way to use moving averages to determine a trend, but it's not the only way. You can also combine and compare two moving averages to define the current trend. For example, you may calculate both a 5- and 20-day moving average for a stock, and then compare them to spot a trend. To do so, work your way though the following steps:

1. Calculate the two moving averages, using the process described earlier in this chapter.

2. Determine which of your two moving averages is fast, and which is slow.

The fast moving average is always the one with the fewest number of data points (closing prices). It's labeled "fast" because its small number of data points makes it prone to change much more quickly (completely different than the reasons someone gets labeled "fast" in high school). The slow moving average is slower to change because of its heftier number of data points.

3. Compare your moving averages to spot a trend.

If the fast moving average is higher than the slow moving average, that indicates an uptrend. The logic is exactly the same as comparing a closing price to a moving average to determine trend, but the fast moving average takes the place of the closing price.

ëIf you notice this type of trend, be more inclined to follow a bullish candlestick pattern and consider buying. If the fast moving average is lower than the slow moving average, that indicates a downtrend. If that's what you see, you should follow a bearish candlestick pattern and look to sell.

Take a look at Figure 11-7, which contains the same data as the previous charts in this chapter, but overlays both a 5- and 20-day moving average. The 5-day moving average is represented by the solid line, while a dashed line is used for the 20-day moving average. You can clearly see the higher volatility of the 5-day moving average compared to the 20-day. And you can also see that the chart indicates an uptrend!

Experts often use a combination of the 5- and 200-day moving averages to define a long-term bull or bear market. These choices may seem somewhat arbitrary, but they've been cemented as rules of thumb in the market.

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