The “trend is your friend.” This is an adage that you hear from many investors. What is a trend? A trend is a direction or trajectory of where prices are moving in based on where it has been in the past. Whether the peaks and troughs are moving up or down indicates the direction of this trend. Investors who follow the “Trend Following” strategy look at the market or the security’s direction as a whole to get a picture of where the market or the security is heading. Investors use different strategies to identify the trend and its strength. Some use trendlines by picking a top and bottom and drawing lines between them; others use moving averages for a dynamic trend indicator using math and others. Investors have different tools that can help identify and take advantage of a trend and profit from it. Which tools to use, however, is another question.
Moving Average to identify a trend?
With different studies and investing strategies popping up, new investors will have a hard time figuring out which ones to use to reliably identify the trend. This is where moving averages come into play. One of its main selling points is how easy it is to add to your chart and removes the subjectivity on where to draw the lines, unlike in trend lines. Since the moving average uses math to determine the moving average, its quantifiable nature allows investors to calculate it based on their preferred periods objectively.
A common example is the 100-period simple moving average. The 100-period simple moving average is the average closing price of a stock over the past 100 trading periods. Many traders consider the 100-period SMA as a go-to way of looking at the intermediate-term trend (commonly referring to 6 weeks - 9 months).
It helps investors and traders visually determine the sentiment on the stock or the market based on where prices are trading (bullish when trading above the SMA and Bearish when trading below the SMA) and the trend based on the direction and angle of the slope. Upward-sloping SMA shows an uptrend, downward-sloping SMA shows a downtrend, and flattening shows a security trading within a specific range of prices.
Pros and Cons of the Moving Average
One of the main advantages of the SMA is that it offers a smoothed-out line that filters out the noise from the sudden movements in the price and gives investors a way to see where the market has been buying and selling it on average based on the determined number of periods. Its slope helps investors visually determine the market they are investing in or trading in. However, with simplicity comes its weakness. Due to the dependency on historical prices, SMA’s tend to respond slower to rapid price changes that often occur at market reversal points. Understanding its strength and limitation can provide an investor with valuable insights and a holistic understanding of when to use the SMA and when to wait for additional confirmation from other supplementary indicators and strategies.
Now, let’s look at 2 sample companies and how we can use the 100-SMA to analyze a stock’s trend.
Microsoft Corp. (MSFT)
Microsoft Corporation is a technology company that creates and provides support for software, services, devices, and solutions. The company is divided into three segments:
- Productivity and Business Processes - this segment includes products and services related to productivity, information services, and communication, available on different platforms and devices. Some examples are Office Consumer, dynamics business solutions, LinkedIn, and Office Commercial.
- Intelligent Cloud - this segment offers server products and cloud services that modern businesses and developers can use, including enterprise services.
- Personal Computing - this segment aims to provide a customer-centric experience with its technology through products and services such as gaming devices, Windows, and search and news advertising.
Understanding the current trend with 100-period SMA
Looking at MSFT’s weekly chart shows how prices and SMA move upward and show us a healthy uptrend. Even with the recent fallout in US banks investors are still bullish on MSFT as the price is now trading above the weekly SMA.
Johnson & Johnson (JNJ)
Johnson & Johnson is a multinational corporation based in New Brunswick, NJ, that manufactures and sells health-related products and services. It is also one of the world's most valuable corporations, employing more than 140,000 active employees. JNJ's operations are segmented into three groups:
- Consumer Health: Provides products based on science approved by medical experts to help people improve their health.
- MedTech: Diverse healthcare expertise and purposeful, innovative technology help save lives and aim to create a future where healthcare solutions are smarter, less intrusive, and more personalized in surgery, orthopedics, and interventional solutions.
- Pharmaceutical: Products distributed through the Janssen Pharmaceutical Companies. Janssen envisions a future in which disease prevention, early detection, treatment, and cure will change thanks to its cutting-edge biologics and other medical components.
Understanding the current trend with 100-period SMA
JNJ’s SMA shows one of the strengths of the SMA by acting as a dynamic support. The chart shows how investors buy in once prices test the 100-period SMA and solidify the bullish sentiment. While prices are currently trading below the 100 periods SMA, once prices touch, the SMA will tell if investors have turned bearish on JNJ.
Final Thoughts
Trading based on the trend has always been one of the popular strategies investors use as it lets them invest in companies based on market bias. However, investors must remember that bias may be founded on fact, rumor, or simply by market psychology. Understanding the pros and cons of an indicator like SMA will keep any investors from overestimating the capabilities of the indicator.
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