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Moving Average Indicator

The moving average indicator is one of the most popular technical analysis tools by traders and investors. Since moving averages smooth a data series, they are very useful to identify trends in markets, stocks, ETFs, commodities, and currencies. Investors use moving averages by themselves as well and in combination with other indicators such as the MACD and the Slow Stochastic. The 50-day and the 200-day moving averages are the most widely used moving average indicators, as they point to the trend of the underlying security.

The type of moving average indicator used by an investor depends on their preference. Some investors prefer simple moving averages, while others use exponential moving averages. They also adjust the time-period used in calculating the moving average. Moving averages help to define the trend.

Type of Moving Average

Traders use 5 to 13 day moving average for short-term trends. 25 to 50 day moving averages help define an intermediate term trend. Long-term trends use moving averages grater than 50 days, such as 100, 150 and 200 days. The best moving average indicator depends on your time frame. If you are examining long market cycles, a longer moving average is appropriate.

Day traders use much shorter time frames as they are looking at minute, five minute, fifteen minute and hourly charts.

In addition, check the frequency of a stock cycle. If it cycles every two months, a good moving average would be 20 days. Use a moving average that is half the cycle length.

Interpreting the Moving Average

Moving average indicators use historical data to help identify and follow a trend. As a lagging indicator, moving averages are unable to identify absolute tops and bottoms of a market or stock. They are very useful in identifying a trend.

A downtrend develops when a stock forms a series of lower lows and lower highs. In this case, the moving average will lag above the trend providing confirmation of the downtrend. Since the slope of the moving average points down, it is a good sign of a downtrend. The degree of lag depends on the time-period used in the calculation of the moving average indicator.

The same holds for a stock that is trending up, forming higher highs and higher lows. The moving average will lag below the price confirming the up trend as it rises. The slope of this moving average indicator will point up, signaling an up trend.

Not surprisingly, a stock that trends sideways will have a moving average that reflects this trend. Most sideways trending stocks trade within a narrow range. When the stock is at the high end of the range it will be slightly above the moving average. When the stock is at the low end of the trading range, the moving average will be above the price. However, the trend in the moving average is sideways as is oscillates up and down. However, this does not happen very often.

The stock chart below of the S&P 500 shows the 50-day and the 200-day moving average over a five-year period.

S&P 500 200-day moving average stock chart

Walking through the chart the market rally that began in 2004, the 200-day moving average rose following the price of the S&P 500 up. Even when the S&P fell below the 200-day moving average the 200-day, the slope of the moving average never turned down. This was a good indication the trend in the S&P 500 remained up.

Once the 200-day moving average indicator turned down following the price, it gave a sign the market was reversing its course and the trend would be down. The slope on the 200-day moving average turned negative in the early part of 2008. While you would have missed the early part of the market’s reversal, following the slope change in the 200-day moving average would have kept you out of the precipitous drop that took place in the second half of 2008 and early 2009. The bear market ended when the 200-day moving average indicator turned positive in the middle of 2009. A new up trend is underway as long as the 200-day moving average indicator points up.

The 200-day moving average is not the only one used by investors. Depending on you investing period, you can use much shorter moving averages as well. Those investors who have a much shorter holding period, will use 5, 9, 12, 13, 20, 30, and 50 day moving averages as their indicator.

In the example above, we only used the slope of the moving average as the indicator of a trend change. Investors and traders use the moving average in other ways to signal when to buy or sell. Here are a few of the methods to apply the moving average indicator:

  1. Use the cross over of the price and the moving average as your trading signal. Only buy when the security is above its moving average. Sell when it is below its moving average. Of course, the time period for the moving average will have a significant influence on this rule. Smaller time periods will cause you to trade more often.
  2. Use the moving average as a support and resistance level. When the price drops down to the moving average and then rebounds, it is a buy signal. Here the moving average acts as support. Should the price fall through the moving average acting as support, it is a signal to sell. The chart below of JoyGlobal (JOYG) shows how the 50-day moving average acted as support during the rally in the share price.
  3. Use two moving averages, each with different time periods. When the shorter period moving average rises through the longer period moving average, it is a buy signal. A move by the shorter period moving average down through the longer period moving average would be a sell signal. In the chart above, the cross of the 50-day moving average down through the 200-day moving average would have worked to help keep you out of the bear market slightly earlier than following the slope change of the 200-day moving average. It also had you enter the market slightly sooner when the bear market ended in June 2009.
  4. Use two moving averages. When the shorter period moving average moves away from the longer period moving average it is signaling the security is trending in the direction of the moving averages. This is the basis for the Moving Average Convergence Divergence (MACD) indicator.
  5. Use the moving average as a trending indicator with other technical tools, such as a chart pattern. The example below shows a breakout of an ascending triangle, a bullish pattern. The 50-day moving average is below the share price as it transitions from a down sloping trend to an up sloping trend when the breakout takes place, confirming the break.

50-day moving average stock chart

The Bottom Line

The moving average indicator is one of the most important tools for technical analysts. As with all technical indicators, it is best to use it with other technical tools to confirm the buy or sell signal. By adjusting the time period on the moving average you can use it with very short time frames to very long ones. The choice of simple or exponential moving average calculation is a matter of preference and what works best for the chart being analyzed.

The moving average indicator signals changes in trends, though it is a lagging indicator. As a result, it will always be late. Hopefully, it also will not give you as many false signals. It is best to use the moving average indicator with other technical methods such as chart patterns and technical indicators that provide good buy and sell signals. The goal is to tip the scale to your advantage, increasing the likelihood of success, while reducing your risk of a loss.

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