Moving averages
A further important tool of trend analysis is the moving average, one of the most widely used technical indicators.
A simple arithmetic mean of a previous run of closing prices is one of the most popular moving averages.
A moving average smoothes the trend, producing a line on the chart that lags behind the price data, but makes the trend more easily identifiable.
Weighted averages can also be used to give more relevance to the most recent price data.
As well as a visual guide to the prevailing trend, moving averages are used to generate buy and sell signals. In a bull market, when the current price drops below the chosen moving average, a sell signal is generated.
A shorter-term average follows the price data more closely, but will generate more false signals.
To smooth out some of the false signals, two moving averages can be used, such as the 10-day and the 50-day. In the bull market example, the sell signal is generated when the shorter-term average crosses below the longer-term one.
There are various ways to decipher their meaning, but one of the most reliable is the golden cross.
This occurs when a line on a graph charting the short-term (50-day) moving average of a share or index moves above its longer-term (200-day) average as they both move upwards.
The logic is compelling.
If moving averages are rising, so should an index or an individual share, at least for a while.
The same also applies in reverse with so-called dead crosses, or sell signals – hence the usefulness of charts for hedge funds.
How long a rise or fall will last is harder to predict.