Among all the technical analysis tools at your disposal—Dow theory, MACD, Relative Strength Index, Japanese candlesticks, and more—moving averages are one of the simplest 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.
Here’s how you can incorporate moving averages to potentially enhance your trading proficiency.
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 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.
- 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 to place 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 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®, 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.
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 price action, and therefore is frequently used to assess short-term patterns. Each moving average can serve as a support and resistance indicator, and is 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.
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 EMA, 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 April 2016 (see chart above). The S&P 500 has gained roughly 7% since then, as of mid November.
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, for example, 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.
Moving averages in action and a few final tips
As a general rule, recall that moving averages are typically most useful when used during uptrends or downtrends, and are usually least useful when used in sideways markets. Generally speaking, stocks have been in a staircase-like uptrend for most of the more than seven year bull rally, so theory suggests that moving averages can be particularly powerful tools in the current market environment.
Looking again at the S&P 500 chart (above), you can see that the long-term trend is up. Also, the price is above the short-term moving average and the long-term moving average. If the price were to decline from the current level, both moving averages would be seen as significant support levels. As the chart demonstrates, 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. However, they can be used in combination with other technical and fundamental data points to help form your outlook.
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