What is the Moving Average Bounce Trading System

The moving average bounce trading system is a pattern in stock price movement similar to a ball bouncing off a moving floor. For example, just like the average height of a female may be 5' 8" a stock price also acquires an average over time. During a typical trading day, the price of the stock may move above or below this average stock price.

The moving average bounce trading system is a system of analyzing financial instruments based on a bouncing pattern produced by a stock price's movement around its moving average. Specifically, the pattern starts by moving away from the moving average, then back toward it and then away again, hence the 'bounce' term.

Why the moving average bounce is meaningful to day traders

The moving average bounce indicates that a stock price or other financial instrument may have reached a new price floor because the bounce is technically the second divergence away from the moving average line. This means the chances of the price moving below the moving average may be lower and a trader hopes this is the case.

Spotting a Moving Average Bounce

Stock price graphs and software applications often chart the course of historical stock price movement and also perform statistical calculations used in analyzing stock price movement. One such calculation is the moving average and can be viewed on stock charts and graphs in the form of a line visibly overlayed on the stock price line. This enables the day trader to compare the stock price to the moving average and spot the bounce.

Timing a moving average bounce

Moving average bounces can occur anytime in a financial instruments trading cycle. In day trading, a moving average bounce is used in a short-term period meaning the period in which the bounce occurs can be minutes. Nevertheless, the actual moving average that is used can be a long term moving average but this is not absolutely necessary and depends on the technique and patterns used in stock trading.

Calculating the moving average

If one has no choice but to calculate a moving average manually the equation is fairly simple. Select a time period such as 30, 60, or 90 days and take three time periods for each of those days. Find the price of the stock for each time period, add them and then divide them by 3 to get an average daily price. Then do this for each of the 30, 60 or 90 days, add them and divide that number by the number of days. The moving average will then have been calculated for the 90th day. In mathematical steps, an example calculation proceeds as follows:

1. Morning price + Midday price + Afternoon price/3
2. Repeat for desired number of days Ex. 30 days
3. Add each days average price and divide by 30

There are several ways to calculate a moving average, and the method one chooses depends on the accuracy one desires and/or the software one uses. Three methods of moving average are simple moving average, 'typical price' moving average and the exponential moving average. The above example uses the typical price method and is an average using a number of averages while the simple average method is just an average.

The exponential moving average gives greater importance to recent prices and is thus a 'weighted' moving average. The formula for this moving average incorporates an exponent with each new days moving average for such weighting purposes and is calculated as follows:
Exponential Moving Average=Stock Close price * Exponent) + (prior days moving average or exponential moving average * (1-Exponent) Where the exponent is calculated by dividing 2 by the number of days in the moving average +1.

The exponent is the key to calculating the moving average using this method and it is calculated by dividing the number 2 by the number of days in the moving average calculation + 1. This must be done for each of the days as in the typical price moving average method above. However, the first day in the calculation which is actually the second day because a previous day must exist for the equation to work properly, will have a larger exponent than the most recent days allowing it to be mathematically weighted.

Conclusion

The moving average bounce is what day traders call a 'technical indicator' meaning it is used in the technical analysis of a financial instrument's price movement. The purpose of the moving average bounce is to signal a possible buying or entry point for the trader. The confidence given to this technique is due to the fact that the bounce is the second rather than the first movement away from the moving average line indicating a possible price floor and predictable movement in the price of the stock.

The actual movement of the stock price may or may not move the direction the trader intends through using the moving average bounce system. However, the bounce system also gives the trader more reason to think the stock price will move in the direction (s)he wishes. Moving average bounces can be observed using technical analysis software, various stock price charts and/or calculated manually. The moving average bounce system may also be used along side one or more other technical indicators.

Sources:

1. http://daytrading.about.com/od/tradingsystems/ss/MovingAverageBo.htm
2. http://www.swing-trade-stocks.com/moving-averages.html
3. http://tinyurl.com/2c9qsl
4. http://www.pandacash.com/technical-analysis/moving-average/exponential.htm
5. http://stockcharts.com/school/doku.php?id=chart_school:technical_indicators:commodity_channel_index_cci