The use of moving averages are important to assessing the price trend of a stock. Even better is using multiple moving averages to increase your accuracy of identifying the stock trend. The definition of a moving average is the average of the stocks closing price over a period of time. As a new closing price is made, it is added to the calculation and the oldest closing price is removed from the calculation. This creates a new data point on the moving average as this process continues into the future.
The simple moving average (SMA) is the total of all closing prices for the time period divided by the number of points in the period. The exponential moving average (EMA) weighs more recent closing prices higher than older data prices as the newest data point is more relevant than older price points. the EMA is more sensitive than the SMA but it has more frequent false signals.
I prefer to use the 20-day SMA and the 50-day SMA in my price charting. There is nothing magical about these SMAs as other investors may use a 14-day and 40-day SMA. I like the 20 and 50 day SMAs as a 20-day is 4 weeks or one month based on closing prices and the 50 day is 10 weeks. I usually sell the current month so the 20-day is more suitable to a one month call option while the 50-day serves as my longer term marker.
What should you look for in moving averages? First, any time one SMA crosses the other the trend has changed (see chart below). When the 20-day crosses ABOVE the 50-day, then the stock is starting an uptrend. Conversely, if the 20-day crosses BELOW the 50-day the trend is moving down. The predictive factor happens when the stock price gaps way above the 20-day SMA as this signals a pullback for the stock.
The best covered call candidate will have the 20-day SMA above the 50-day with a flat or uptrending price line. If the 20-day is below the 50-day, I usually pass on the stock as there are so many other stocks better suited to a profitable covered call trade.
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