Have you ever wondered why a stock bounced when you thought there were no reasons for it do so? In most cases, the moving averages help explain why.
We’ve covered a lot already and if you’re new to technical analysis, then most of this information would have overwhelmed you. The reason why the articles are spread out weekly is so that you can practice what you learned for a week before moving onto another topic. The last thing we want is for you to go into sensory overload, so if I’m going too fast, just let me know. At this point, you should be very interested in technical analysis if you’re following my articles each week. If you’re taking the time and energy to learn as much as you can, I commend you for that.
Moving averages are an absolute minimum, mandatory requirement for technical trading. They are one of my most favorite indicators and I do not even consider a trade without looking at the relevant moving averages. Have you ever wondered why a stock bounced when you thought there were no reasons for it do so? Even a stock without support lines or trend lines bounced, so how do you explain that? In most cases, the moving averages are responsible for sudden, sharp movements.
A moving average is simply the average value of a stock’s price over a certain length of time. There are several uses for moving averages:
- They can determine momentum
- They can show “invisible” support and resistance
- They give traders a head start in placing high-probability trades
- They signal warning of a breakdown
- They support the consensus of other technical indicators
All moving averages are lagging indicators, meaning that they will react to price and not foreshadow it. Moving averages work in trending stocks and do not work well when a stock is in a neutral trading range. CF Industries (CF) is an example of a stock that is trending.
There are many types of moving averages (simple, exponential, variable, linearly-weighted), but we will only cover the two most widely used: the simple (SMA) and exponential (EMA) moving averages.
The SMA is calculated by taking the average price of a stock over a certain period of time. So if we look at the above 100-day moving average, we would add the closing prices of the last 100 trading days and then divide the number by 100. This calculation gives equal weight to each day.
The EMA is calculated as either percent-based or period-based. I won’t be covering the exact mathematical formula because all you really need to know right now is that the EMA cuts down the lag time by distributing more weight to recent prices and less weight to older prices. The shorter the EMA (in days), the more weight is designated to the most recent price. Therefore, the EMA is almost always closer to the current price vs. the SMA.
Which one should you use? The difference is small, but there are large differences if a stock becomes more volatile. I like to use the EMA for shorter time frames, such as if I am day-trading or swing trading because any sudden changes are quickly factored into the moving average. If I am position trading or holding for several weeks, then I’ll use the SMA because the EMA is too sensitive to small changes and will give false signals, making it less effective in longer time frames.
Now that you know about the two most common types of MA’s, you have to know what periods to use. Since traders are all different, they all have their own set of MA’s that they work with. It’s important to always find the MA’s that work for you. Here is a sample guideline for what MA’s to use:
Long (buy) trades:
- 15-day SMA (short-term)
- 20-day SMA (short-term)
- 50-day SMA (intermediate-term)
- 200-daySMA (long-term)
Short (sell) trades:
- 10-day SMA (short-term)
- 15-day SMA (short-term)
- 50-day SMA (intermediate-term)
- 200-day SMA (long-term)
The key lesson to learn is to make sure the moving averages actually guide a stock. If a moving average does not provide accurate support or resistance guidance, then there is no point in using it. Not all stocks follow the same moving averages.
The bottom line: if a stock is about to meet a MA that the stock has used in the past, then there is a very high chance that the stock will react to the MA. In MEE’s case, the 25-day SMA acted as short-term resistance and a trader could short the stock once MEE approached the 25-day SMA.
Below, we can see the 20-day SMA provided short-term support for the CBOE Volatility Index (VIX) in many instances. We can also see that the 50-day SMA provided recent intermediate-term support.
Besides using MA’s as support or resistance, you can also employ MA crossovers. Many times, when an MA “crosses over” with another, that movement generates a buy or sell signal. The most accurate signals come from shorter time frames because remember, MA’s are lagging indicators.
Remember: When a shorter period MA crosses above a longer period MA, that’s considered bullish. When a shorter period MA crosses below a longer period MA, that’s considered bearish.
Crossovers apply to all periods. Below, we can see the U.S. Oil Fund (USO) following the 40-day SMA perfectly. If you were a long-term investor, you might have wanted to put up the 100-day and 200-day SMA’s. In the first green box, we can see the 40-day SMA crossing below the 100-day SMA. That was an instant sell signal. Investors had one last chance to sell when the 40-day SMA crossed below the 200-day SMA. I suggest traders to use much shorter periods (like the ones I listed in my guideline for long and short trades above) to react more quickly to breakouts and breakdowns. Nonetheless, an investor would have protected most of his/her profits at the first cross over.
Fact: On the first trading week in January 2008, the market easily cut through the 200-day SMA. This complements the head-and-shoulder pattern that formed starting in mid-2007. These were clear warning signs that the market was weakening and heading lower in the future.
Fact: If investors and traders had simple knowledge of the 200-day SMA as a long-term indicator, they would have saved $10 trillion by going into cash. Short-sellers, like myself, made a handsome profit, multiple times, on the way down. It has taken you only a few minutes to learn this, but most investors don’t bother to learn it (and instead complain why they are losing money), that’s why…
The reason why I commended you for learning in the beginning of this article was because now you are starting to pick up the knowledge to become successful. Can you imagine how much you’ll learn twenty articles from now? By now, you realize how important MA’s are to trading. For practice, take a look at several stocks and apply my guideline MA’s to them. If they don’t fit, try your own MA’s! Do this over and over until you’re accustomed to applying certain MA’s to different stocks. Always apply them, and never trade without them!