For as long as the stock market and charts have been around, using this one line in your trading, you would’ve been able to see where the market was going. With this line, you could have avoided financial crises like the Dot Com bubble, or the subprime crisis in 2008. And knowing this pattern, you’ll be able to protect yourself from other future financial crashes which are bound to hit the market.
Let me explain…
Moving Averages are vital to your trading tool kit
Before I show you how awesome this tool is, I’m going to first tell you what it is. A moving average is a lagging indicator that shows you the average price of a share over a certain period of time (minutes, days, weeks, months etc…).
So, it will give you the weight to each day’s prices.
For example, let’s look at five days of the closing prices of a company’s share.
Share price for day 1 = R100
Share price for day 2 = R95
Share price for day 3 = R103
Share price for day 4 = R106
Share price for day 5 = R108
Then to work out the moving average of the share prices over five days, you simply do this…
Add the share prices (SP) of all five days and divide into those five days.
So you get, = SP 1 + SP 2 + SP 3 + SP 4 + SP 5
5 days
= R100 + R95 + R103 + R106 + 108
5 days
= R102.4
This means that the R102.40 is the average price over the five days of share prices.
Now every day, you’ll see that the average price will change which will drop off the old data and show a new price level.
When you’ve accumulated a few weeks of data, you’ll see the average price of the share will move up or down. And, you’ll see the line will smooth out the noise and craziness, so you’ll easily see which direction the overall trend is going. You don’t have to calculate a thing!
Nowadays, from the most simple to the most advanced, almost all charting software has an option to choose moving averages. And it will do all of the calculations for you, so you don’t have to.
I just explained how the moving averages work and how the points are calculated, so you know what you’re dealing with. Use this moving average and you’ll be able to protect yourself from possible future financial crises.
So in your charting software, first go to the Johannesburg All Share Index or the ALSH.
Once you have the chart opened, go to where you can add in an indicator and look for the tool called the Simple Moving Average or the SMA.
You’ll want to change the simple moving average to 300 SMA. So, this will calculate each point on the SMA graph by adding the last 300 days closing prices and getting the average (dividing by 300).
This is what you can expect to see…
So you can see that the Blue line is a smooth 300 SMA which cuts out most of the noise.
With the 300 SMA, you’ll clearly see which direction, the Index is currently going.
When the price is above the 300SMA you’ll note that it continues on an upward trajectory.
You can clearly see this looking at the green arrows, in the above chart.
When the price breaks below the 300SMA, this should ring warning bells and should tell you that the price has potentially changed its direction to the downside.
If the price is below the 300 SMA, here’s how you can protect your portfolio from any nasty recessions
There are a few ways to mitigate your risk and limit your losses if the Index price breaks below the 300SMA.
You can either cut your exposure by half or more, if you feel uncomfortable about the market breaking below the 300SMA. With the price below the 300SMA, it could mean that the market is entering into a bear market (continuous downside).
Or you can simply wait for the price to go above the 300 SMA before you decide to pile into the shares. This could help protect your portfolio from suffering magnified losses.
Watch out if you have these sectors in your portfolio when price is trading below 300 SMA
The shares that are most negatively affected during financial bear markets include shares in the resource, banking and insurance sectors.
Now you should have a better understanding on how to use Moving averages to avoid market crashes.
