Moving averages are not unlike trendlines; they not only help measure the direction and momentum (the relative angle) of a trend, but can alert us to when a trend has reversed on a short to intermediate-term basis.
A moving average is a lagging indicator based on past closes only. (There are also moving averages of the highs and lows occasionally used.) A significant difference between trendline use and moving averages is that, whereas the break of a trendline can alert us on a pretty immediate basis that a trend is reversing, we need to wait usually to see if a close puts a stock or index above/below a key moving average. Moreover, I generally have a rule of thumb that it takes TWO consecutive Closes above/below certain moving averages to 'confirm' a short-term trend reversal; or, at least that the dominant trend has been interrupted for some period. Use the two day 'rule' takes out some instances where stops were run, but the trend reasserts itself the next day.
While it's at the end of the latest trading period being measured that we see if the most recent Close is above or below the moving average, we often see hourly, daily or weekly highs or lows bounce off from key moving averages. This can be contrasted to when prices penetrate or pierce a trendline, where this penetration is seen immediately, although we also want to see if the Close is going to pierce the trendline in question.
I have some very recent examples of price action relative to what I find is a key moving average (21-days) for bellwether stocks and especially for the major stock indexes. Use of a 21-day moving average is especially useful for trader types. Those with an investment orientation will tend to use a 50-day moving average; i.e., a move above or below this average suggests a possible shift in the intermediate-term trend. The bigger trend picture tends to get 'defined' by where prices are relative to a 200-day (40 week) moving average. 'Fundamentally' oriented fund managers, who might look at almost nothing 'technical' WILL pay attention to the 200-day average.
As to my suggested use of the 21-day average for the major indexes, the Dow 30 (INDU) chart is of interest which is my first chart. You'll notice that INDU came down to the area of the moving average but the lows held above it. The rebound that followed shouldn't have been surprising, although the Dow hadn't dropped much in terms of the Relative Strength Index (RSI), suggesting a continued tendency for the market to rally in spite of being relatively overbought. 'Relative' being the key word here as stocks or indexes in very strong trends should be evaluated more on the basis of trend following type indicators, which includes the use of moving averages.
I mention on my chart notation above that the S&P pierced its 21-day moving average. The S&P 500 (SPX) daily chart is shown next. While SPX did Close below this key trading average, the index came back the next day as the lows were about equal and on a closing basis, SPX was back above the average.
What about an index where there were 2 consecutive Closes below the 21-day average? We saw this with the tech heavy Nasdaq.
The Nasdaq 100 (NDX) chart, reflecting the biggest tech stocks and having led the market for months, is shown next in terms of TWO moving average: the 21-day and the 34-day closing moving average. Why 21 and why 34 anyway in terms of the length setting for an average? For the same reason I tend to use of 8 and 13 and sometimes 55 as an indicator input (including the RSI). These numbers are part of the Fibonacci number series: 1, 2, 3, 5, 8, 13, 21, 55, etc. The most recent TWO numbers add up to the next number in the series. Fairly simple but the concept of the Fib numbers tends to reflect numerical markers that show the progression of a trend. And the way that rabbits multiple! Well, that was how the Italian mathematician, Fibonacci, came up with this progression in the middle ages.
The next number in the Fibonacci series after 21 is 34. That length setting for NDX is of interest in my next chart and my notations on the chart show why.
I have some historical examples of how certain other moving averages in common use helped 'define' resistance.
The decline seen in my next chart took the Nasdaq Composite (COMP) under the widely followed 200-day moving average. Use of the 50-day (you could use 55 also) average suggested some additional areas to short bellwether tech stocks or to buy puts in the NDX. The fact that some of these shorting opportunities were at resistance implied by the top end of the downtrend channel was a definite 'confirming' technical indication of resistance. I am always looking for as many technical factors as possible that line up bullishly or bearishly.
Other indicators that were of interest in conjunction with moving averages in the COMP chart seen above occurred in mid-March of the year shown, when COMP was both deflected from the area of its 200-day moving average AND was registering as overbought according to the stochastic indicator. While there was one close above the average in this example, the lack of follow through the next day, given the overbought conditions, was the tip off to buy index puts and/or to short bellwether stocks in the index.
In the period shown above, the S&P 500 rebounded to above the 50-day average for two days running and had one Close above the upper end of the bearish downtrend channel. This pattern suggested at a minimum that it would be prudent to close out bearish short-term trading positions. By the way, the rally that started during the late-2002 period shown, ended up going to the 1100 area (by early 2004).
We can anticipate that a fairly major technical milestone comes with a 'test' of the 200-day moving average. When we say that a moving average is tested the reference is usually to whether a stock or index close pierces (goes through) the moving average in question or NOT. If prices pierce the moving average, there is then a watch on whether on subsequent hours, days or weeks, prices ALSO stay above or below the moving average in question. As long as this is the case, I would tend to trade more heavily on the long side on pullbacks.
For shorter-term options trading, the key moving averages to follow the trend will range from as low as 5 or 8, on up to 13 or 21, all length settings for daily charts. In a bearish downtrend, a move up to but not beyond these averages are often put buying opportunities, especially in the case of the 21-day average. There are times where there is of course only ONE close above/below some key moving average as the item in question lacks follow through in the same direction the next day.
In the case of a single close above/below a key moving average and where other technical factors leave you in doubt about whether this event is merely a fake-out move or whether it's a trend reversal, it can be useful to wait and see if there are the TWO consecutive closes above or below the moving average. Typically or most often, a true trend reversal will occur on more than one single penetrating Close, whether on an hourly, daily or weekly chart basis; i.e., there will be at least two consecutive closes that pierce the moving average. My next chart, of GE, shows the 200-day (thick dark magenta line) and 50-day (thin light magenta line) averages:
It can be useful to use combinations of moving averages as a trading input. For example, buying some puts on an initial downside penetration of a 5 or 8-day moving average, especially if there are other bearish chart considerations (e.g., a breakout below a trading range), but only taking one-half of the number of options of a usual purchase. A further purchase could be made after a close below the 13 or 21-day moving average.
It is also often appropriate to wait for a time and see if a support/resistance 'role reversal' comes into play. If the 50 or 200-day moving average has been coinciding with a series of highs or lows and these averages are frequently stopping or 'deflecting' price swings, such moving averages are acting as resistance or support. Just as with prior lows or highs and with trendlines, their can be role reversal. Once 'broken' (pierced), support can 'become' resistance and resistance become subsequent support.
For example, the 21 or 50-day moving average has been acting as support on a decline or in a sideways trend. Prices then decline below the 50-day average and keep falling in the short-term. On the next rebound the 50-day average 'deflects' the rally. Such price action relative to the moving average should be assumed, until otherwise resolved, to be a definite sign of a bearish trend reversal.
As declines often LOSE ground faster than advances GAIN ground with the price breaks sharper, there will typically be fewer occasions of prices rebounding back up to and then being deflected by, a key moving average; there are some occurrences of course.
Let's assume the reverse situation and that there's an upside breakout above some important moving average like the 200-day, which has been previously 'acting as' resistance. However, prices rally above the average and keep going in the short-term. If the index or stock then falls back to the average, only to rebound again, this provides an alert technically of a bullish upside reversal.
If other technical and fundamental aspects are also 'supporting' what is going on with a moving average penetration, the moving average break can provide a reason to initiate a trade. If so, the exit point on say long calls might be a move of a certain amount below the moving average; on long puts, a move back above the moving average by say 3-5% could be an exit point.
When a market or individual stock begins a sideways consolidation or goes into a trading range, the 50 and 200-day moving averages will, over time, flatten out. At this juncture the moving averages will act as a support area at times and offer resistance at other times, as can be seen in the chart below used in my (Essential Technical Analysis) book:
Difficulties are presented in knowing if one should stay in a shifting trend like the one shown above. If prices are moving above or below a key moving averages during these sideways trends or non-trending periods, use of exit points based on moving averages can result in being whipsawed. Being whipsawed is just a way of saying that soon after entry, there develops an opposite trend direction signal as closing prices 'whip' back and forth, above and below the moving average(s)in question.
To help avoid this frustrating situation, I tend to use whatever technical analysis tools might be providing a clear direction, such as seen in top or bottom patterns (e.g., double top, rounding bottom), trendline analysis and making use of key moving averages as a 'confirming' or secondary tool. An example is seen in my last chart:
GOOD TRADING SUCCESS!