Keep Your Portfolio Moving With Moving Averages

(by Bryan Perry)

Options traders are always looking for ways to predict how the market will move, and you've likely heard professional traders talk about a stock's moving average, which can help you to gauge whether it's time to buy puts or calls.

The term simply means the average closing price for a stock over any period -- 200-day, 50-day or even five-day moving averages are some of the more common, and significant, measures.

For instance, a 50-day moving average is calculated by adding the closing prices for the last 50 days and dividing the total by 50. After the next trading day ends, the oldest day's closing price is dropped and replaced with the newer figure.

The point to this exercise is that the moving average smoothes out day-to-day swings in prices and creates a recent context in which to judge a stock's price trends.

So, over time, the average moves as new data is added and old data is dropped. This calculation is known as a "simple moving average," as each day in the trading period carries equal weight.

There are other, more complex types of moving averages -- exponential, triangular, variable and weighted are some of the more popular ones. But as you're getting started with looking at technical analysis and trends, the simple moving average (which is also known as an "arithmetic" moving average) may be the most important one for you to learn first.

Moving averages serve to even out stock price fluctuations, making it easier to spot trading trends. And, of course, "the trend is your friend," but it can be difficult for even the savviest traders to spot them, because stocks -- and, by proxy, their option chains -- don't move in a straight line.

Time frames also come into play when considering the usefulness of the information moving averages provide, and it's important to consider a stock's short-term and long-term performance. Short-term traders use the 10-day moving average, traders who buy and hold for a few weeks or months look at the 50-day moving average and longer-term investors consult the 200-day moving average for the type of performance they want for as long as they anticipate holding the security.

But because the data could be subject to interpretation, traders could look at each average and see a different trend, either upward or downward. So, the key is to decide which trend or trends apply to your style of options trading.

Many options traders only consider buying call options when a stock's price is trading above their preferred moving average and buying put options when a stock's price is trading below that level.

For some option traders, moving averages can also serve as sell signals. If a stock closes below its moving average at the end of a trading day, this could be a signal that it's time to bail on the calls because the stock may be likely to start a downtrend. Conversely, if a stock closes above its moving average, it could be time to consider closing put option positions because it indicates the stock may rise.