Among all the technical analysis tools at your disposal—Dow theory, MACD, Relative Strength Index, and more—moving averages are one of the easiest to understand and use in your strategy. Yet they can also be one of the most significant indicators of market trends, being particularly useful in upward (or downward) trending markets—like the long-term uptrend we have been experiencing since 2009.
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 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 the chart below).
There are a few different types of moving averages that investors commonly use.
- Simple moving average (SMA). A 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 five 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 it places more emphasis on the most recent 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). They are also an important component of other technical indicators—such as Bollinger Bands®.
Setting up moving averages
When setting up your charts, adding moving averages is very easy. In Fidelity's Active Trader Pro®, 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.
How are moving averages used?
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, U.S. stocks are trading above both their 50-day and 200-day EMA. The 50-day EMA would act as the first moving average support level, in the event of a short-term decline, followed by the 200-day support level acting as a secondary support level.
The golden cross and the death cross
Two moving averages can also be used in combination to generate 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 fast moving average crosses above a slow 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. Using the chart of the S&P 500 above, the most recent crossover was a gold cross in early April 2016 (see chart above). The S&P 500 has gained 19% on a total return basis since then, as of mid-May 2017.
Alternatively, a sell signal is generated when a fast moving average crosses below a slow 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.
A golden cross or a death cross does not suggest that you should mechanically buy or sell. Rather, it is one piece of information that may suggest a change in the trend.
Moving averages in action and a few final tips
As a general rule, recall that moving averages are typically most useful when used during clear uptrends or downtrends, and are usually least useful when used in sideways, non-trending markets. Generally speaking, stocks have been in a staircase-like uptrend for most of the more than eight year bull rally, so this general theory suggests that moving averages can be particularly powerful tools in the current market environment. As the chart demonstrates, note that it is possible for the price to remain above (or below) a moving average for an extended period of time.
Of course, you would not want to trade solely based on the signals generated by moving averages. Moreover, you should consider each investment opportunity on its own merit, including how it aligns with your investment objectives and risk constraints. However, moving averages can be used in combination with other technical and fundamental data points to help form your outlook on an individual stock and also on the overall stock market.
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