The Moving Average is a widely used indicator in technical analysis that helps to smooth out price action by filtering the noise from random price fluctuations.
It is a lagging indicator as it is based on past prices. The two basic and most commonly used MAs are the Simple Moving Average (SMA) and Exponential Moving Average (EMA).
The Simple Moving Average is the simple average of a security over a defined number of periods. The 21 SMA will be the average price of the stock over the past 21 days.
The Exponential Moving Average is similar to the SMA, but gives bigger weight to more recent prices. For this reason, we primarily use EMAs on intraday charts.
The most common applications of moving averages are to identify the trend direction and to determine support and resistance levels. They are also great as trailing stops, when used properly.
In this LN chart below, we can see how it lost all momentum once it lost it’s 8 SMA (yellow line). In fact, the 8 SMA acted as resistance for LN on the way down. Traders everywhere are looking for it to reclaim it's 8 SMA to the upside which may enable some long positions and a movement higher.
Different moving averages can mean different things, so let's go over the most important ones we use:
The 8 & 21 SMA - The most important moving averages for short term, momentum trading. If you are long, you want your stock to be on top of these MAs with them acting as a support level.
In this DE breakout, we can see the 8 SMA (yellow) guiding the stock higher, acting as support, with the (blue) 21 SMA not too far behind it.
If you were long this stock in a short term position, it may not be a bad idea to trail a portion of your position using the 8 SMA.
The 200 SMA - This MA is technically the most important for a stock's long term chart. It is the line in the sand that deems a chart healthy or unhealthy. It is the most widely used indicator by hedge funds around the world. When a stock is around this MA, you can be sure there are a lot of eyes on it. While we don't base trades off moving averages, rather use them as a layer of probability, many traders do. The traders who base trades off MAs are those who trade more long term.
Once GOOGL pierced through it’s 200 SMA, it immediately found support and bounced in the days to follow. It remains to be seen whether or not it will hold, but you can tell it acted as support for now.
The 100 & 50 SMA - These are both important indicators as well. These don't hold the same weight as the 200 day, or mean as much to momentum traders as the 8/21 day, but the 100 & 50 SMAs are important in their own right.
Utilizing Moving Averages to Grade Daily Charts
How do we use moving averages on the day to day? We use them to deem the health and probability of a move higher or lower for a stock.
If you want to go long a stock, you ideally want it to be above all of the aforementioned moving averages, with the moving averages curling up.
Here's one of the trades we recently sent out, BBY Long:
After looking at the moving averages, are you surprised it went higher? Do you see how the moving averages are all curling up? These are all positive signs.
Conversely, after ILMN missed earnings, they sold off hard. Now every moving average acts as resistance. Even though it's down so much in the past month, it still looks like you can short this through lows based on the chart. Do you see how the moving averages are now curling down when they were curling up before? Bad sign.
In summation, Moving Averages are important indicators, but at the end of the day they are just indicators. They can act as a layer of probability for your prospective trade. For example, ILMN looks like a solid short, all the moving averages are curling down and everytime it tries to push higher the 8 and 21 SMA act as resistance causing it to sell off. Remember, if you are looking to go long a stock, you prefer it to be sitting atop it’s major moving averages with them curling upwards. If you are looking to short a stock, you want it’s daily candles underneath it’s major moving averages, with them curling downward.
Understanding moving averages plays a large role in fully utilizing technical analysis to gain an edge. Moving average crossovers are a common way traders can use Moving Averages when analyzing a chart. A crossover occurs when a faster Moving Average (i.e. a shorter period Moving Average) crosses either above a slower Moving Average (i.e. a longer period Moving Average) which is considered a bullish crossover (or below which is considered a bearish crossover). We can see two clear examples of this in the SPY daily chart over the past month. The bottom circle indicates the 8 SMA crossing over the 21 SMA which in turn indicates a change of downward trend (for the short term). This trend is confirmed by the higher circle, when the 8 SMA then crosses the 50 SMA. These are tactical indicators that tell you it may be time to get long.
Do you have balls?
In the Chart Reading Group chat post 2 example of MA crossovers and circle where they occurred.
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