The stock market ride has become increasingly bumpy over the past several months. Thus far, the S&P 500 has closed higher or lower by more than 1% in either direction over half of the trading days this year (see chart, % of days with S&P 500 daily close >1%).
When markets are shifting to this extent, moving averages may be a particularly useful tool to help you see through the noise and identify trends as they are unfolding.
Among all the technical analysis tools at your disposal, moving averages are one of the easiest to understand and use in your strategy. As a supplement to your fundamental analysis of an investment opportunity, or to add insight to an investment you already own, here’s how you can incorporate moving averages to potentially enhance your trading proficiency—and what they may be signaling about the US stock market now.
What are moving averages?
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 financial security's normal movements can sometimes be volatile, gyrating up or down, which can make it somewhat difficult to assess if there is a pattern forming in its general direction. The primary purpose of moving averages is to smooth out the data you're reviewing to help get a clearer sense of the trend (see chart, A moving average smooths out the price).
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.
Moving averages can be implemented on all types of price charts (i.e., line, bar, and candlestick), and are also an important component of other technical indicators—such as Bollinger Bands®. 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 the long-term uptrend we have been experiencing since 2009. Of course, trends can be broken at any time, and there is no guarantee that the market is still in an uptrend.
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.
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.
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 below their 50-day EMA. They most recently broke below the 50-day EMA (a bearish signal) in March 2018 and have remained below this indicator since then. This moving average now serves as resistance; if stocks can break above the 50-day moving average and hold, this could be considered a bullish sign.
Stocks signaled additional weakness by breaking below the longer-term 200-day EMA a couple of times over the past several months. Since then, the S&P 500 broke above the 200-day moving average, and is currently still trading above this level. If it were to break below this support level again, that would be considered a bearish signal by many.
What should be clear from this price action is that 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.
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 short moving average crosses above a long moving average. For example, the "golden cross" occurs when a moving average, like the 50-day exponential moving average, crosses above a 200-day moving average. This signal can be generated on an individual stock or on a broad market index, like the S&P 500. The last crossover was a golden cross in early April 2016. The S&P 500 has gained roughly 29% on a total return basis since then, as of mid-April 2018.
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 early 2016. The next possible crossover signal, given that the last one was a golden cross, is a death cross. Looking at the chart above, the 50-day moving average has been dipping toward the 200-day moving average, and a sustained correction could result in the death cross trigger.
Of course, 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
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. Generally speaking, stocks have been in a staircase-like uptrend for most of the more than 9-year bull rally, so this general theory suggests that moving averages may be particularly powerful tools in the current market environment—if the market is indeed trending. Also, it's worth noting that 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.
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.
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