Ever wonder why moving averages are used by so many traders? It seems that no matter which chart you look at there is always at least one moving average on there. Is it a self fulfilling prophecy at this point that because so many traders use them that we are all responding to them or is there something more to them? If so, how can we make the most of it?
There are three extremely popular moving averages that seem to be used on almost any time frame. First is the 20 period moving average which is used more for the short term traders but can also be used for longer term traders looking for clues in the short term. The second is the 50 period moving average which is typically used on a daily time period to help those in the mid to long term identify changes in trend. The last is the granddaddy of all, the 200 moving average. This is also typically used on a daily time period.
The first thing that so many traders use this for is simply to identify trend. The moving averages offer a quick way to see the consistency of an uptrend or downtrend. If you are long a stock and it's trending above the 20 day moving average then you would be hard pressed to find someone interested in selling that stock.
The other thing traders use these moving averages for is to gauge over extension. Look at any stock or index and you can see that if it moves to sharply away from it's 20 day moving average (or any for that matter) then it will always come back to it. Typically when a stock snaps back towards the moving averages it happens rather abruptly as well so traders will always want to be on alert for a stock that is moving to sharply away from the moving average.
Moving averages are no magic indicator, rather an additional tool you can use to identify moments in time where you may want to enter with others or simply close a position.