Moving Average Analysis

Module 5: Technical Indicators
Lesson 6: Moving Average Analysis

Moving average analysis is one of the most important components of successful options trading. Determining whether your stock is trending or not, can be the difference between a profitable trade and a losing trade.

It's a way to separate the winners from the losers.

We haven't discussed stock chart analysis yet, but it will be covered in the next learning module. Moving average analysis is a component of stock chart analysis. They are usually both done at the same time.

Stock chart analysis is performed when you are creating a list of stocks to watch. It's also the practice of reviewing your stock charts every day, or week, looking for potential trades.

You're looking for, or asking yourself a number of things:

  • What do the moving averages tell you about the trend of the stock?
  • Where are prices headed and where do they look like they are headed?
  • Are there any particular price patterns you notice? Support, resistance, etc. etc.
  • Does the stock have a lot of volatility (up and down movement) or is it fairly stable?
  • Etc. Etc.

Before you proceed you may want to re-read the overview on moving averages. It will help everything in this lesson about moving average analysis sink in.

So What Exactly is Moving
Average Analysis?

Moving Average Analysis is when an options trader reviews the moving averages on a stock chart to determine the direction of the trend and to spot trade entry and exit points.

When you are performing your moving average analysis you will notice two distinct features of moving averages:

  1. The shorter the moving averages are (5, 7 day, etc.), the closer they will mimic price movement.
  2. And the longer the moving averages are (30, 200 day, etc.), the longer it takes for the average to "catch up" with price movement.

So what moving averages do you use?

At this point in your journey you may have no clue what moving averages to use nor how long to stay in a trade.

Let me give you a simple rule of thumb to use until you become more experienced with moving averages. After you're more experienced you can change things around in whatever way you feel is necessary.

As a beginner I suggest you...

  • Review your stock charts on a 6 month time frame.
  • And place 7 and 30 day simple moving averages on your stock chart.

Moving Average Analysis
Trend Identification and Confirmation

For the particular style of stock option trading I'm sharing with you, we will primarily use moving averages to...

  1. Help us determine the stock's trend
  2. And for entry and exit confirmations

I use the 30 day simple moving average to determine the trend of the stock.

So when you are doing your stock chart analysis you will observe the 30 day moving average. Is it trending up, down, or is it flat?

  • If it's trending up, you're going to trade call options on the stock.
  • If it's trending down, you're going to trade put options on the stock.
  • If the stock is not trending and is forming a sideways channel, then you either move on to find another stock or you can trade covered calls on the stock.

**Trading Tip**
If you're only going to trade call and put options like I do, then look for trades on stocks that have a strong trend!!! If the trend (moving average) is flat, then move on to find another stock. The stronger the trend, the better your technical indicators will work and the more money you'll make.

To illustrate moving average analysis, I'm going to use the three stocks I provided for you on the stock chart analysis page, as well as their stock trend analysis scores (as of the time of this writing).

Ross (ROST) Score: +100

TJX Companies (TJX) Score: +100

Google (GOOG) Score: +100

According to the stock trend analysis help section, a score of +100 means that, "A strong uptrend is in place and the market (or stock) will likely remain in a long-term positive direction."

Let's pull up one of the charts to see. Since all three stocks have the same stock trend analysis score I'll just use the stock chart of "TJX":

moving average analysis

When I first started trading, I performed stock chart analysis each night looking for trending stocks and possible trade signals.

Now I have software perform my stock trend analysis and I only look at the stocks that have a strong trend. The software saves me from reviewing hundreds of stock charts myself and frees up a great deal of my time.

No computer has ever been created that can spit out trades for you. So ALWAYS use your human judgment as the final say so.

Even my wife remembers when I reviewed a hundred or so stock charts each night. It was my daily ritual. Out of the 100 I viewed, I'd maybe find 10-20 that were worth looking at.

I do recommend beginners get into the habit and practice of reviewing stock charts until they learn how to spot trends and fully understand how moving averages work.

When you are confident you understand the process, and are ready to automate that part of your trading, then sign up for the free stock chart analysis and have the results e-mailed to you daily.

Moving averages are lagging indicators. A lagging indicator is a technical indicator that produces results after the fact. They always lag behind prices and are a step behind.

Lagging indicators are generally not a good tool to use for trade entry signals, because they'll get you in the trade too late.

Lagging Indicators are good price confirmation tools.

If you recall from one of the previous lessons, a trigger (or trade entry signal) is when a market condition that you specify is met. This trigger alerts you to the fact that a potential trade is on the horizon.

An example of a trade entry signal (trigger) is when one of your leading indicators (Slow Stochastics, Williams %R, etc.) produces an overbought or oversold signal.

You would not enter the trade until you received some type of price confirmation to back up the overbought or oversold signal. This is where moving averages are useful.

Moving Average Analysis
Entry and Exit Confirmations

Again, for the particular style of stock option trading I'm sharing with you, we will primarily use moving averages to…

  1. Help us determine the stock's trend
  2. And for entry and exit confirmations

I use the 7 day simple moving average for most of my entry and exit confirmations.

When one of my technical indicators has produced an oversold signal, I will wait for prices to rise above the 7 day moving average before I enter the trade.

If one of my technical indicators produces an overbought signal, then I will wait for prices to fall below the 7 day moving average before I enter the trade.

For an overview of the terms overbought and oversold, please check out the lesson on technical indicators

Let's use the same chart of "TJX".

On the chart below, I've illustrated how I use the 7 day moving average. I have removed the technical indicator from the picture so that your focus is only on the 7 day moving average.

moving average analysis

Signal #1: I had an oversold signal here and would normally wait for prices to rise above the 7 day moving average before I enter the trade (price confirmation), BUT the 30 day moving average was flat/down so I would have ignored this signal.

Signal #2: I had an oversold signal, but this time the 30 day moving average was in a strong up trend so I would have been more comfortable buying a call option once prices trended above the 7 day moving average.

Prices also rose above the 7 day moving average on higher volume so this was an added bonus. Not necessary, but just an added bonus.

Moving average analysis is an easy skill to learn, and one that is extremely important to the success of your trading.

In the next lesson, I will tie everything together and show you how to use the technical indicators and moving averages together.

You'll also learn the trading process from beginning to end and watch me actually make a trade.

Please proceed to Module 6 Lesson 1: Online Options Trading.

Module 5: Technical Indicators

Module Lessons

  1. Using Technical Indicators
  2. Slow Stochastics
  3. %R Momentum Indicator
  4. Relative Strength Indicator
  5. MACD Indicator
  6. Moving Average Analysis

Module Instructions: According to how the site is set up, you are now in Module 5: Lesson 6 (Moving Average Analysis). For the most effective learning experience, read through each lesson in this module one by one, in the exact same order as they are listed in the table of contents to the left.

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