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Moving average trading signal

Key takeaways

  • 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 buy signal.

It’s official: Stocks are in a bull market. The S&P 500 has gained more than 20% from the October 12, 2022 closing price near 3,577. Expectations for a Fed pause on rates (which they did on Wednesday, deciding not to lift rates for the first time in over a year) and a resolution to the debt ceiling have helped drive stocks higher this year.

But many investors remain wary of a potential recession, a resurgence in inflation, real estate worries, and other factors that threaten to derail 2023’s momentum.

With that said, chart users are seeing a mostly optimistic outlook, including those that use one of the more popular indicators—moving averages—which appear to suggest the bullish trend may be here to stay.

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.

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. The primary purpose of moving averages is to smooth out the data you're reviewing to help get a clearer sense of the trend.

These are the 2 most popular 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.

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 applied to the S&P 500

Source: Active Trader Pro, as of June 13, 2023.

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 above their 50-day (light blue line) and 200-day (orange line) EMA. Both moving averages may be support levels going forward and, in fact, the 50-day moving average has acted as support several times over the past couple months.

Fast and slow

Shorter-term moving averages are frequently referred to as "fast" because they change direction on the chart more quickly than a longer moving average. Alternatively, longer-term moving averages can be referred to as "slow."

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. 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 S&P 500 experienced a golden cross in early April, when the 50-day EMA crossed above the 200-day EMA. Stocks have rallied sharply since then, up nearly 15%. The next crossover signal to look for would be a death cross.

A few final tips

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.

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.

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. Right now, moving averages are suggesting the bulls may keep running.

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Technical analysis focuses on market action — specifically, volume and price. Technical analysis is only one approach to analyzing stocks. When considering which stocks to buy or sell, you should use the approach that you're most comfortable with. As with all your investments, you must make your own determination as to whether an investment in any particular security or securities is right for you based on your investment objectives, risk tolerance, and financial situation. Past performance is no guarantee of future results.

Past performance is no guarantee of future results.

Stock markets are volatile and can fluctuate significantly in response to company, industry, political, regulatory, market, or economic developments. Investing in stock involves risks, including the loss of principal.

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