Definition
First, let's define a moving average. For our purposes we are discussing a Simple Moving Average. This is calculated by taking the closing price of the previous X number of periods, and dividing by X.
For example:
The 5-Day Moving Average of a stock whose closing prices for the week were, $50, $53, $55, $55, and $52, would be $53.
50 + 53 + 55 + 55 + 52 = 265
265 / 5 = 53
That's all there is to a simple moving average. As the name suggests, it's simple. Perhaps that's what gives it such importance in the markets. Now that we know what a moving average is, let's take a look at how to use them.
Why Does a Moving Average Matter?
There is an old saying on Wall Street that you would do well to remember, "The trend is your friend until it bends at the end." One of the first things we look for in a potential trade is what the current trend is. But, what does that even mean? Something can be immersed in a brutal downtrend on a 30-minute chart, while being wildly bullish on a daily chart, and vice versa. What you see depends entirely on what you are looking at.
To smooth out some of the noise, we look at moving averages. As shown up above, a moving average is simply a line drawn on the chart that shows the average value of the previous period of time in question. For example, a 20-period moving average on a minute chart shows the average price of the previous 20 minutes of price action, while the 20-period moving average on a daily chart shows the average price of the previous 20 days.
A moving average can have any value, really, and traders will often change the length of time to more closely align with the price action of a specific security. Sometimes, a 20-DMA (Day Moving Average) will touch a couple of different candles, but if you zoom in or out, you can get a closer fit to see where potential support or resistance might be.
In general, we look closely at three different moving averages. First, the 200-DMA. Looking at a moving average of the past 200 days shows us what the primary, long-term trend is. If we are looking to go long, we want this to be sloped higher and if we are looking to go short, we want to see the moving average slope down. Since so many traders look at this moving average, expect it to often have a powerful influence on the price of a security.
Look at the chart below and notice how Palladium bounced along its 200-DMA before finally rallying away from the average. But, as is often the case, the greater the distance from the 200-DMA, the more powerful the "snap back" correction will likely be.
We are particularly interested to see if a security is above or below the 200-DMA, and what the slope of the 200-DMA is. In general, we want stocks that are above (but not too far above) a rising 200-DMA.
Next, the 50-DMA. The 50-DMA shows the more intermediate trend and is more sensitive to the latest price action than the 200-DMA is. The 50-DMA does a good job of showing the current, medium-term trend. It is another moving average that is closely watched by Wall Street, and stocks have a high probability of reacting when they get near it. Traders who prefer trades that take more than a month to reach their target will want to watch this average.
In general, traders will do well to avoid stocks that are below a falling 50-DMA. These stocks are immersed in a downtrend, and it will take a good bit of luck to pick the bottom. On the other hand, a stock that declines to its rising 50-DMA and then begins to bounce is called a Kiss 50 and is often a good trade setup. You can see a number of examples of this in the chart below.
Finally, we have the 20-DMA. For many shorter term swing traders, the 20-DMA marks the sweet spot. The 20-DMA is much more reactive to the current price action than the 200, or even the 50-DMA is. The 20-DMA will still filter out much of the intraday market noise, but it is more subject to market swings, and is less reliable for portraying what the long-term trend is. There are a couple of techniques we like to use when trading around the 20-DMA.
When a stock is in a strong uptrend, it will often decline to the 20-DMA before bouncing. This type of trade is very similar to the Kiss-50 trade discussed above, except we use the 20-DMA instead of the 50-DMA. By using a shorter term moving average, it takes less of a market correction to offer a trading opportunity. A pullback to the 20-DMA appeals to momentum traders much more so than a pullback to the longer term moving averages.
Recap
And there you have it. Three different moving averages that each represent their own slice of time, and can all have an outsized influence on the price. To recap:
200-DMA—Appeals to long-term value investors. It reveals the price trend of the past 200 trading days.
A simple technique is to buy stocks that are rising above or bouncing off of their 200-DMA, and selling stocks that decline below their 200-DMA. A trader could likely find long-term success even if this is all of the due diligence that they do. By employing this simple technique, it is possible to avoid stocks that are immersed, or about to begin, a longer term downtrend.
50-DMA—Shows the trend of the past few months. It is closely watched on Wall Street, and the price will very often bounce off of this moving average.
A popular trading technique is to buy when the 50-DMA crosses from below to above the 200-DMA. This is called a Golden Cross and is an indication that a longer term trend change is taking place. Another popular trading technique is the Kiss-50 trade.
20-DMA—The 20-DMA will primarily appeal to shorter term traders. The average hold time for someone that exclusively uses this moving average will be much shorter than it would be if one were using the 50 or the 200-DMA. Traders will do well to only look for long opportunities when the moving average is sloped higher, and look for selling opportunities when the average is sloped lower. I like to think of the 20-DMA as the yellow line on a road. You always want to be on the correct side of the yellow line.
A popular trading technique is to buy when the price rises above a flattening or rising 20-DMA on strong volume. This suggests a trending move is just beginning, and catching the beginning of such a move will often provide gains that lasts days to weeks.
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This post was written from the boat in Bonaire. Our children are truly Wanderers, and are earning their trading chops all over the world. But aside from learning about investing, they are enjoying a lot of scuba diving, and windsurfing. We've also spent time at the Bonaire donkey sanctuary, and exploring the National Park, scattered lighthouses, and digging into the Caribbean history of the island. Hands on learning and experiences out in the world.
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