Moving Averages

How to Use Moving Averages in Your Trading

While I am not a huge fan of elaborate technical indicators, moving averages are another matter entirely. They provide a good look at momentum, which is the key factor to consider when trading.

The main reason that moving averages are so important is because they are the simplest technical indicator class, and everyone uses them (sometimes without knowing it). Many technical indicators start from moving averages and build superstructures over them.

Because moving averages are so universal, moving averages acquire an importance far beyond their natural utility. It is unnecessary to explain what a moving average measures - the name is self-explanatory - and because traders and robots base their decision on them, that alone imbues them with insight into what others are thinking. There may not be anything magical about, say, a 50-day moving average crossing a 200-day moving average, but the fact that so many watchers attach significance to that movement because of what has happened in similar situations in the past gives the cross-over significance.

Here are some general pointers. Please note that different moving averages come into play in different situations, and a particular moving average may give insight into a market one month, while another moving average may acquire significance in another month. Adjust always to what is working.

Ten things traders need to know about moving averages.

1. The 20-day moving average commonly marks the short-term trend, the 50-day moving average the intermediate trend, and the 200-day moving average the long-term trend of the market. The SPY is generally the best tracking ETF for the market in general.

2. In sharply trending markets, the 5 day exponential moving average and the 10 day simple moving averages to have meaning as entries and exits to help manage my positions when the longer term moving averages are too far away.

3.  Exponential Moving Averages apply more weight to recent price changes, while Simple Moving Averages view each data point in the time frame equally.

4. SMAs let you see where other traders both big and small are buying and selling. The meaning of moving averages as support and resistance points  on charts are a result of how other traders are reacting when they are touched by price.

5. Where the price on the chart is in relation to the 200-day moving average is an indication of whether we are in a bull or bear market. Generally speaking bulls keep their confidence to stay long above the 200-day moving average, while bears like to sell short below it. Bears usually win and sell into rallies below this line, and bulls like to buy into pull backs above it. This line is one of the biggest signals in the market telling you which side to be on. Bull above, Bear below. many long term trend following systems are built with this as a primary indicator.

6. When the 50-day moving average pierces the 200-day moving average in either direction, it supposedly predicts a substantial shift in buying and selling behavior. The 50-day moving average rising through the bottom to get above the 200-day moving average is called a Golden Cross which is bullish, while the bearish piercing of the 50 day coming from above and falling beneath the 200 day is called a Death Cross. A simple cross is not necessarily determinative, but a cross with confirmation over time acquires huge significance.

7. A great second chance entry on a hot stock is a retaking or bouncing off a 50 day moving average for the specific stocks chart. Many institutional buyers are waiting at the 50 day sma to add to their long term positions.

8. Getting a monster stock with huge future earnings potential at the 200 day is like a gift from the trading gods and usually happens as we come out of a bear market. However if the 200 day is lost it is very dangerous and could begin a fall with no net, this is a time to short the old leaders that may go into death plunges.

9. Some traders use systems that give buy and sell signals when a shorter term moving average crosses over a longer one. Legendary trend trading pioneer Richard Donchian used a five and twenty day moving average cross over system for buy and sell signals.

10. Some traders watch for when a moving average begins to slope upwards or downwards and consider it as a signal of a trend beginning, continuing, or changing.

If you are day trading, different rules apply, though the ideas are the same. For instance, the 200-day moving average is not very important if you are in and out of trades within minutes. In those situations, I have found that the 20-period moving averages on the different charts are quite handy. A 20-period moving average on a four-hour chart, for instance, will tell you the general trend over days and weeks, while a 20-period moving average on a five-minute chart can be useful in providing entry and exit points.

The main take-away lesson is that you should have moving averages in your arsenal any time you enter or exit a trade, and you need to decide beforehand which ones are important and bear watching.