This can be a complicated market for some investors to navigate, including active investors. Stocks have recouped much of their COVID-19 losses, but the risk of a down market remains very high while the economic impact of the pandemic looms. Historic fiscal and monetary programs have helped support stocks and other investments. On the other hand, the recent uptick in new coronavirus cases around the world—coinciding with the gradual reopening of global economies—remains a major cause for concern.
Add to this uncertainty that the effectiveness of some short-term trading strategies can be blunted by overwhelming market moves in reaction to new COVID-19 information, and you have a market that might be particularly difficult for active investors to analyze. Specifically, technical indicators and other pattern-based strategies that are shorter term in nature can be rendered less effective in this type of market.
With that said, one indicator that you might find useful to help see through some of the higher-than-normal volatility is a moving average. Here's why this indicator suggests there may be strength ahead for US stocks over the near term.
What are moving averages?
As a supplement to your fundamental analysis of an investment opportunity, or to add insight to an investment you already own, you can incorporate moving averages to potentially enhance your trading proficiency.
Among all the technical analysis tools at your disposal, moving averages are one of the easiest to understand and use in your strategy. Moving averages may be a particularly useful tool to help you see through the noise and identify trends as they are unfolding.
A mean is simply the average of a set of numbers. A moving average is a (time) series of means; it's a "moving" average because as new prices are made, the older data is dropped and the newest data replaces it.
A stock or other investment's normal movements can sometimes be volatile, gyrating up or down, which can make it somewhat difficult to assess if a pattern is forming. The primary purpose of moving averages is to smooth out the data you're reviewing to help get a clearer sense of the trend.
There are a few different types of moving averages that investors commonly use.
- Simple moving average (SMA). An SMA is calculated by adding all the data for a specific time period and dividing the total by the number of days. If XYZ stock closed at 30, 31, 30, 29, and 30 over the last 5 days, the 5-day simple moving average would be 30 [(30 + 31 + 30 +29 + 30) / 5 ].
- Exponential moving average (EMA). Also known as a weighted moving average, an EMA assigns greater weight to the most recent data. Many traders prefer using EMAs because they place more emphasis on the most recent market developments.
- Centered moving average. Also known as a triangular moving average, a centered moving average takes price and time into account by placing the most weight in the middle of the series. This is the least commonly used type of moving average.
Fast and slow
Shorter moving averages are frequently referred to as "fast" because they change direction on the chart more quickly than a longer moving average. Alternatively, longer moving averages can be referred to as "slow."
Moving averages can be added on to all types of price charts (i.e., line, bar, and candlestick), and are also an important component of other technical indicators. In terms of when to use moving averages, they can be helpful at any time. However, they are considered to be particularly useful in upward or downward trending markets.
You can choose between different moving average indicators, including a simple or an exponential moving average. You can also choose the length of time for the moving average. A commonly used setting is to apply a 50-day exponential moving average and a 200-day exponential moving average to a price chart (see Moving averages applied to the S&P 500 chart).
Moving averages in action
Moving averages with different time frames can provide a variety of information. A longer moving average (such as a 200-day EMA) can serve as a valuable smoothing device when you are trying to assess long-term trends.
A shorter moving average, such as a 50-day moving average, will more closely follow the recent price action, and therefore is frequently used to assess short-term patterns. Each moving average can serve as a support and resistance indicator, and each is also frequently used as a short-term price target or key level.
How exactly do moving averages generate trading signals? Moving averages are widely recognized by many traders as potentially significant support and resistance price levels. If the price is above a moving average, it can serve as a strong support level—meaning if the stock does decline, the price might have a more difficult time falling below the moving average price level. Alternatively, if the price is below a moving average, it can serve as a strong resistance level—meaning if the stock were to increase, the price might struggle to rise above the moving average.
As the S&P 500 chart above shows, US stocks are currently trading above their 50-day (orange line) and 200-day (blue line) EMA, both of which could act as support for stocks over the short term. Recently, the S&P 500 climbed above both moving averages (a bullish signal). Of course, a decline below these moving averages would be interpreted as a negative short-term trading signal.
The S&P 500 used the 50-day EMA as support earlier this month, and had used the 200-day EMA as support numerous times over the past 6 months (excluding when stocks crashed through both the 50-day and 200-day EMA in late February—a sell signal).
The golden cross and the death cross
Two moving averages can also be used in combination to generate what is perceived by many traders as a powerful "crossover" trading signal. The crossover method involves buying or selling when a shorter moving average crosses a longer moving average.
A buy signal is generated when a shorter-term moving average crosses above a longer-term moving average. For example, the "golden cross" occurs when the 50-day exponential moving average crosses above a 200-day moving average. The thinking among chart users is that this price action illustrates a change in sentiment from bearish to bullish. This signal can be generated on an individual stock or on a broad market index, like the S&P 500.
The S&P 500 experienced a golden cross on June 15, when the 50-day EMA crossed above the 200-day EMA—a bullish indicator for chart users.
Alternatively, a sell signal is generated when a short moving average crosses below a long moving average. This "death cross" would occur if a 50-day moving average crossed below a 200-day moving average. The last death cross occurred in mid-March. It is worth noting that this crossover signal was not prescient, as most of the S&P 500's COVID-19 losses had already occurred by this time.
Obviously, a golden cross or a death cross do not suggest that you should mechanically buy or sell. Remember, indicators like moving averages can generate signals that you may not want to act upon, depending on your strategy. There have been several crossovers by the 50-day and 200-day moving averages over the past several years, and trading these signals may not have aligned with your objectives. Rather, these crossovers are an additional piece of information that may suggest a change in the trend.
A few final tips
Adding moving averages
When setting up your charts, adding moving averages is very easy. In Fidelity's Active Trader Pro®, for example, simply open a chart and select "Indicators" from the main menu. Search for or navigate to moving averages, and select the one you would like added to the chart.
As a general rule, recall that moving averages are typically most useful during uptrends or downtrends, and are considered least useful during sideways, non-trending markets. Also, it is possible for the price to remain above (or below) a moving average for an extended period of time, as the chart above demonstrates. Moving averages can give frequent, and sometimes conflicting, trading signals. It's up to you to determine which signals you consider significant. Moreover, these signals should never be acted upon in isolation.
And, as previously mentioned, indicators may not be as reliable when exogenous threats like the COVID-19 pandemic are overwhelming market action.
Finally, you would not want to trade solely based on the signals generated by moving averages. Each investment opportunity should be evaluated on its own merit, including how it aligns with your investment objectives, risk preferences, financial circumstances, and investing time frame. Moving averages can be used in combination with other technical and fundamental data points to help form your outlook on an individual stock and on the overall stock market.