The first is to ascertain the underlying trend in the relevant market and attempt to exploit it. This, along with risk management and a realistic target with respect to exiting a trade, can put you on the right track to having longevity and an element of success in the financial markets.
Theory of moving averages
Moving averages can be employed to smooth out short term fluctuations, making it easier to get to grips with the general trend of an instrument, as well as identifying potential market turning points. Important to note is that moving averages work best in markets that are displaying a definite trend; a trendless (sideways moving) market will not lend itself well to the effective use of the tool.
Remember also that the moving average calculation will lag behind the current price and this can therefore cause it to provide misleading information. The extent of this lag is affected by the number of events used to calculate the average, which can vary from two or three events to over 200. Longer moving averages in particular are subject to this lag; they tend not to predict price directions, but rather reflect current direction.
When examining a stock or index, it’s always worth looking at the price action in relation to the 200-day moving average; the grandfather of all the moving averages. It is something which will likely be referred to by major market players such as hedge funds and pension plans. Simply put, a financial instrument trading above its 200-day moving average is deemed healthy, while those below it are seen as somewhat anaemic.
FTSE still healthy
Right now, the FTSE has neither crossed below the 200DMA, nor have we seen a bearish crossover of the 50 and 200 averages. Today’s rise back through the 6300 level, following the rebound of the 38.2% retracement level from June 2012 lows, may well be a result of a dead-cat bounce, and it’s certain that there is more resistance overhead than support down below (from a technical perspective).