Question:
What are the indications that a share price has bottomed or topped its current trend?
Response:
There are many ways to potentially identify if a share has bottomed or topped in a current trend. One of the most popular ways to identify the end of a trend is through technical analysis. Often the easiest way to do this is through a Moving Average. A moving average is one of many trend-following indicators that attempt to identify a trend in its early stages. By identifying the start of a new trend you should also be able to determine whether a share has either hit the top or the bottom of the trend.
Trend following is perhaps the most widely used technical trading approach, and much of the focus of technical analysis methods centre on identifying when a trend has started. You might often hear the saying, ‘the trend is your friend, until it bends in the end’. The simplest and most widely used trend following indicator is the Simple Moving Average (SMA). It is called a simple average as it takes the sum of a number of closing prices (let’s say ten) and divides by the number of days or periods. The average “moves” because every day you drop the oldest piece of data and insert the most recent closing price.
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The essential purpose of the simple moving average is to smooth out the raw price data. A moving average does this by removing some of the erratic fluctuation from the raw unsmoothed prices. Then, rather than looking directly at a line of closing prices, you can refer to the SMA line, which is easier to interpret.
A popular way to use the SMA is to measure two different timeframes and apply what is known as a crossover to determine whether a trend has finished. A crossover occurs when one moving average crosses over another moving average. Usually a short-term average will cross over a long-term moving average indicating a Buy or a sell. If a short term moving average is below the long-term moving average and crosses above the long-term SMA that will indicate a buy. If the Short-term moving average is above the long-term average and moves below, it will indicate a sell.
An SMA is a trend-following indicator. With these tools there is a trade off between reliability and responsiveness. By lengthening an average, you target longer term trends, trade less frequently and miss out on smaller trends and a greater proportion of the profit from longer trends. Conversely, by shortening an average you target shorter term trends, trade more frequently, capture smaller market movements, and a greater proportion of the profits from longer term trends. This is the inherent trade-off involved in using trend-following methods.
It is critical to understand and accept that every indicator involves some form of trade off and there is no perfect solution. With the vast resources available with current trading platforms such as webIRESS, it is a relatively simple task to visually display SMA and add multiple timeframes with ease.
By Matt Press, Head of Sales, FP Markets
Other articles in this week’s newsletter
The Stockies Awards – Who You Chose As The Best In The Industry
Keep Holiday Debt From Snowballing
How to know if a share price has bottomed or topped
Takeover Target Internet Stock
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