Moving Averages: A Clearer Picture

Moving averages are one of the simplest technical indicators, and they are very useful for determining a stock's trend or to confirm a reversal. Moving averages are also the building blocks of more developed indicators like MACD.

This post will showcase how we can use moving averages to identify trends and likely areas of support and resistance. We can also use them to confirm when a trend has changed.

What are moving averages?

A moving average is a calculation of a stock's average closing price over a prior period of time, such as the prior 50 days. You can use any amount of time to calculate a moving average, but 20, 50, and 200-day moving averages are common calculations. You can even use 20-week moving averages, in which you calculate using the weekly closing price instead of the daily. In this example, we will use the 50-day moving average (50-DMA).

When the trader's software or website (like stockcharts.com) calculates the 50-DMA, it takes the stock's average price from days 1-50 and plots that value. The following day, it will take drop day 1 and take the average price from days 2-51. This daily calculation change continues, and the different calculated prices connect to form a line. This line is the 50-DMA.

Moving averages are lagging indicators. They only tell you what happened in the past and cannot predict the future. However, by looking at multiple data points on lagging indicators, you get a good sense of a trend. For example, if a company's earnings report (a lagging indicator) shows increased revenue each year, it's a good bet the trend will continue. The same concept applies to moving averages.

In the above, we see the 50-DMA in blue and 200-DMA in red. SPY has gone up so quickly that if we take the average price from the previous 200 days, then it's barely even on the screen. 

What can we use moving averages for?

There are 3 traditional uses of moving averages:

1) To identify trends;
2) To identify likely points of support and resistance;
3) To confirm swings in momentum (crosses).

Let's check out all 3.

1) Using MAs to identify trends. In a chart like SPY above, we don't need much analysis to see that the stock is trending upward. When the stock's price stays above the moving average, then the bullish trend is intact, even if it experiences some red days. Anyone who buys shares will likely see the stock continue to rise in their favor. On the other hand, when a stock is below its moving average, then the stock's bearish trend is intact. 

If a stock's price crosses over the moving average, then the trend may be broken. It is wise to wait a few days to confirm that the stock doesn't cross right back over and continue the original trend. But if a bullish trend breaks, then it is usually a good time to go bearish.

In Feb, PTON dropped below its 50-DMA and began a downtrend. Buying puts shortly after the change in trend would have printed over then next 3 months.

In late Feb, LOW dropped below its 50-DMA and continued down another $20 to its $200-DMA (we will talk about how DMAs can create support or resistance in the next section. LOW just recently crossed back below its 50-DMA again. If it does not recover its 50-DMA very quickly, then it will likely begin a period of decline.

Bonus: Notice how the bullish divergence on RSI indicated a likely change in momentum. See yesterday's post on RSI.

2) Using MAs to identify likely points of support or resistance. Have you ever heard someone say, "the stock bounced right off the 50-DMA?" Moving averages indicate likely points of support or resistance because if traders believe a trend will continue, they will be happy to react when the stock goes back to its "average" price. This can be a good buying opportunity during an uptrend or selling opportunity during a downtrend.

Each time SPY tapped its 50-DMA, the stock bounced off and continued the uptrend. The 50-DMA provides support. Traders often see the stock's average price (its moving average) as an opportunity to enter at a good price. Thus, buyers arrived in force to scoop up shares at every opportunity. This continued the uptrend, and shareholders are quite happy.

Note that since a stock can hover near or just below its moving average for several days, it is best to wait for the stock to demonstrably bounce off or crash through its average before taking a new position. If it bounces, you can then buy. You may not have nailed the bottom, but that is okay; it is just fine to narrowly miss the bottom in exchange for avoiding additional risk. 

ARKK in 2021 shows us a great example of moving averages. In late Feb, ARKK dropped below its 50-DMA and failed to recover it. This indicated a downtrend had begun. In mid-late April, ARKK bounced off its 50-DMA to the downside, possibly because bagholders saw it as a good price to get out. The 50-DMA provided resistance. The downtrend continued another $25 before it began recovering. Now, ARKK is attempting to recapture its 200-DMA and 50-DMA at around the same time. Its chart shows it is likely to bounce off and continue declining. However if it recovers to $120, it would likely indicate a positive reversal.

3) Confirming swings in momentum. Identifying when stocks crash through or bounce off moving averages is helpful. But to confirm an even longer-term change in momentum, we can observe MAs crossing each other. When the short-term MA (like the 50-DMA) crosses over the long-term MA (like the 200-DMA), then we get a really clear picture of a long-term momentum swing. We will use the 50 and 200-DMAs in these examples.

Golden Cross: When the 50-DMA hooks upward through the 200-DMA, this is called a golden cross. This is a strong buy signal. It indicates that momentum has clearly swung to the upside, and the stock price is likely to remain above the rising MA, which provides support.

Death Cross: When the 50-DMA hooks downward through the 200-DMA, this is called a death cross. This is a strong sell signal. Momentum is to the downside, and the 50-DMA will likely start serving as resistance.

In Jan, D experienced a death cross that confirmed a downtrend. The stock continued down another $8, which is a lot for a utility company with consistent dividends.

In mid-May, D made a golden cross. So far, that bullish indicator has not played out. RSI and MACD look bearish, but the golden cross is usually a pretty good indicator. I would not be surprised to see D put up a strong fight and use the 200-DMA for support. 

A more amicable example, in mid-Feb, AMC made a golden cross which demonstrated momentum to the upside even after the initial frenzy abated. AMC generally glided off the 50-DMA after that until it ultimately rocketed higher over the past few trading days.

What is an exponential moving average?

The above examples use the simple moving average, which is the most common. Traders can also use the exponential moving average, but this is uncommon. 

The EMA places more weight on prices in the immediate past, whereas simple moving averages consider day 1 and day 50 equally relevant. 

The EMA is used to calculate MACD, which is my favorite indicator. But EMAs are not often used by themselves.

Final Thoughts

- Moving averages have patience. A death cross or golden cross may take a little while to play out, but they are very good indicators for price movement over the following 60 days.

- Use moving averages in conjunction with other indicators. If you see a MACD crossover or bullish RSI move at the same time the stock is bouncing off the 50-DMA, then you have a very good probability of success if you go long.

- Wait a few days after a bounce off an MA to confirm the move, rather than assuming the bounce will happen. It is okay to miss the very bottom and then take out the sweet spot.