Boost your trading toolkit by watching moving averages

FUNDAMENTAL traders have been speculating for some time about two trends: a resurgent greenback and an asset price bubble in China. And, if the technical analysis is correct, confirmation of both these moves came at the end of last week.

On Wednesday, the US dollar index – which is a measure of the US dollar relative to the majority of its most significant trading partners – closed above its 200-day moving average for the first time since last May, while China’s Shanghai Composite Index closed below its 200-day moving average for the first time since March 2009.

But what is a moving average, and how can it be used by spread betters to detect long-term shifts in the market? It is calculated by adding together the closing price of the security over a specified number of time periods and then dividing this total by the number of time periods.

The shorter the time period, the more quickly it responds to changes in price, whereas a long-term moving average such as the 200-day one, moves much more slowly and tends to indicate a long-term reversal in sentiment. This makes last Thursday’s events significant in the market.

When a stock or index is trading above its 200-day moving average, it is considered to be in a long-term uptrend. When the price is trading below the 200-day, it is considered to be in a long-term downtrend.

According to analysts at Bespoke Investment Group, the moves in the US dollar index and the Chinese stock index “are confirmations that the trends could be in place for longer than some thought”.

While such moves are not always confirmed – fakeouts are very common indeed – the breaks through the 200-day moving averages appear to have some strength. On Friday, the dollar index hit a five-and-a-half month high, while the Asian markets suffered from flagging risk appetite.
Analyst David Woo at Barclays Capital has just revised upwards his euro-dollar forecast for the next six months, putting three- and six-month euro-dollar at $1.35 (from $1.40) but keeping his 12-month forecast at $1.45.

And concerns about China have only been made worse by Beijing tightening policy further in recent days. The moving average technical analysis seems to be in line with the fundamentals.
When assessing the strength of an asset breaking through its long-term moving average, traders can apply filters to moves to eliminate fakeouts, says Tom Pelc, technical analyst at RBS. For example, you could require that the index spends an entire day trading above the moving average or perhaps look for a weekly close above the average.

Pelc also suggests looking at point and figure charts, which plot day-to-day price movements without taking into consideration the passage of time. These charts are used to filter out non-significant price movements and allow the trader to determine support and resistance levelss
These techniques can help spread betters avoid market pitfalls. Once the long-term trend has been confirmed, traders should then be looking for the short-term moving averages – such as 50-day and 100-day – to cross over the long-term moving average. This points to sharper moves ahead and experienced spread betters might look to increase the size of their position at this point.

Moving averages cannot and should not be used without reference to other technical analysis and the fundamentals. But you can tell at a glance what the general direction of an asset is. Just don’t get wrapped up in them to the extent that you ignore everything else.