- Moving averages are one of the simplest and most commonly used technical indicators.
- Short-term buy and sell signals can be generated by crossovers of 2 moving averages.
- The most recent moving average crossover generated a sell signal.
At this time last year, stocks were rolling en route to a 28% gain for US stocks (as measured by the S&P 500) in 2021. What a difference a year makes. US stocks officially entered a bear market on June 13, after falling more than 20% from their most recent high. Rising gas and other prices have increased the probability that the US central bank could keep raising interest rates to fight inflation (including the 0.75% hike on June 15), and that has played a big role in pressuring stocks this year.
Of course, a multiyear chart doesn't paint as pessimistic of a picture. Nevertheless, many active investors are wondering if the selling pressure could continue over the short term, or if stocks might find a bottom.
From a chart perspective, a tool that you can use to watch for a continuation or change to the current trend is moving averages. A signal given by one use of this indicator suggests that US stocks might continue to push lower, but economic trends—perhaps most notably if prices broadly start to cool down and the Fed doesn't feel it needs to raise rates as rapidly—have the potential to change that dynamic.
What are moving averages?
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 some 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—like this stock market.
In most trading platforms, 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 being indicators of 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. If a stock does fall below a support level, that can be considered a short-term sell signal. Alternatively, if a stock rises above a resistance level, that can be considered a short-term buy signal.
As the S&P 500 chart above shows, US stocks are currently trading below their 50-day (light blue line) and 200-day (orange line) EMA. The 50-day moving average had acted as support several times in 2021 during the uptrend. But 2022's bear market has pushed the S&P 500 below both moving averages. If markets find a bottom, both of these lines would now serve as resistance.
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, 2020, 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. This has been the more recent crossover signal, having occurred in March 2022. Stocks have spiraled lower since then, and officially entered bear market territory in June. The next crossover signal to look for would be a bullish golden cross.
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.
Obviously, a golden cross or a death cross does not suggest that you should mechanically buy or sell. You shouldn't buy or sell based solely on any single indicator. 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.
Additionally, 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. You can incorporate moving averages to potentially enhance your trading proficiency as a supplement to your fundamental analysis of an investment opportunity, or to add insight to an investment you already own.
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.
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