Averaging is one of the most basic things we all do with math. It smooths out big sets of numbers and helps us grasp bigger patterns. Technical analysts use the same approach with the stock market, often finding opportunities to buy and sell in the process.
Moving Averages Show Trends
Moving averages take the mean, or average, of prices on a chart. They’re backward looking, so a 10-day moving average will use the 10 previous closing prices. Each price point on the chart will show the average from earlier periods.
Moving averages can be applied to any time frames, from intraday to daily or weekly.
Traders often consider a stock to be in an uptrend if it’s above a moving average, and in a downtrend when below it. Moving averages can also give directional signals when they’re rising or falling. Steeper angles provide clearer signals.
Alternately, flat moving averages that go from left to right on the chart can indicate a range-bound market.
Moving Averages Can Be Simple or Exponential
There are two main types of moving averages, based on the way they’re calculated:
- Simple moving averages (SMA): A simple average, or mean, of all the price history. Each period is weighed equally. SMAs are often used for longer time frames.
- Exponential moving averages (EMA): A weighted average that places greater importance on the more recent prices. This makes them more reactive and highlights quicker changes.
Buying the Pullback With Moving Averages
Traders often wait for pullbacks or retests of moving averages to enter positions. When a stock is rallying, they may wait for it drop back to a key moving average. They can also sell short (or buy puts) when a downward-trending stock rebounds to a moving average.
Medium-term traders often use the 50-day SMA, and longer-term investors may watch the 200-day.
Still, not all pullbacks are created equal. A spell of aggressive selling, often with heavy volume, might rip straight through a moving average. Calm and steady descents are often better opportunities.
Also, the first pullback to a moving average after a breakout tends to work more effectively. As time passes and the stock tests the moving average several times, it becomes less likely to hold.
Moving Average Crossovers
Because moving averages show trends, it can be meaningful when prices cross above or below. Some traders use these as signals to buy or sell.
Say a stock has been trending higher but then falls below its 50-day moving average. That could indicate its uptrend has ended. The opposite may be true if a downward-trending stock closes above its 50-day.
Another common signal is when a shorter-term moving average crosses a longer-term moving average. That can also signal a change of trend in your trading system.
You may have heard market commentators mention these terms about moving average crosses:
- A “Golden Cross” (potentially bullish) is when the 50-day SMA rises above the 200-day SMA.
- A “Death Cross” (potentially bearish is just the opposite, with the 50-day DMA falling below the 200-day SMA.
Moving Averages and Risk Management
Some traders use moving averages in their risk management. For example, they may exit a long position when a stock breaks under its 50-day SMA. That way a position closes itself without your emotions getting in the way.
Still, moving averages have limits because they’re backward looking. They can help you quickly identify trends, but are less useful when prices aren’t following a clear direction.