A common tool used by traders for identifying a stock price trend is moving average charts.
Moving average indicators measure the mood of the market by revealing the directional trend of a stock.
It is a smoothing technique that removes abrupt, choppy fluctuations (noise).
Understanding the Moving Average System
A stock’s closing price represents the opinion of “the crowd,” that is, the majority of traders, regarding the value of that stock for that day.
By averaging the closing prices of a stock for several days or weeks, the general direction the stock is moving becomes apparent.
Once a stock starts moving in a particular direction, it often gains strength, and usually does not reverse easily.
As each new day comes, the oldest price in the period being averaged is replaced by the closing price of the new day, and the average is recalculated.
This continuing calculation through time gives it the name “moving average”.
You can plot both a long-term and a short-term moving averages and compare their relationship to each other.
You can also look for times when short- and long-term lines cross each other, as this can indicate a change in a stock’s price direction.
Values used for these short- and long- day trends are typically 8, 10, 20, 50, 100 and 200 days.
A Look at 5- and 20-Day Moving Averages
Figure 1
Figure 1 plots a 5-day and 20-day moving average.
The line that hugs the candlestick line on this chart is the 5-day simple moving average (SMA), and the smoother line is the 20-day simple moving average.
Note that the stock makes a dip in price, but then continues its uptrend, while the 20-day SMA shows that the stock is still in an overall uptrend, despite the pull back.
Consider Also: What is a Stock Portfolio and How Does it Work?
Exponential Moving Average EMA
Exponential moving averages (EMAs) are more reliable for short-term forecasting than simple moving averages (SMAs).
Exponential moving averages weigh the most recent prices heavier than previous prices, unlike simple moving averages, which weigh all prices in the time frame equally.
The EMA is better for swing traders than the SMA, because it provides clearer trending signals.
We like using the 5-day exponential moving average to indicate the short-term direction and the 20-day exponential moving average to indicate the longer-term direction, as it tends to be good at predicting price direction (Figure 2 below).
• When the 5-day EMA crosses above the 20-day EMA, an uptrend is indicated.
• When the 5-day EMA crosses below the 20-day EMA, a downtrend is forming.
Figure 2
Moving Average Charts
All charting websites have the capability to plot simple and exponential moving averages using different time periods.
You can quickly plot a 5-day EMA and a 20-day EMA on a chart and compare them (as well as any SMA or EMA plots you want).
These EMA technical indicators can be displayed on most free bar chart programs including:
Setting up a 5-day EMA and a 20-day EMA on most charting sites is fairly easy, but it might not be quite so obvious on another popular site, tradingview.com.
So, here’s the step-by-step procedure for that charting website:
1. Enter the ticker symbol to display a chart.
2. Click on the “Full Features Chart” button.
3. Click on “Indicators”.
4. Scroll down the alphabetical list of indicators to Moving Average Exponential, and click on it. At the upper left of the chart, “EMA (9, close)” will appear, indicating a 9-day EMA. Three small gray boxes appear next to that text. Click on the center icon (looks like a gear) to edit, and change the 9 to 5.
5. Again, click on “Indicators,” scroll down to Moving Average Exponential once more, and click on it.
6. Another “EMA (9, close)” appears underneath the first one. Click on the middle gray gear and change the 9 to 20.
There you have it…a nice chart showing both the 5-day and 20-day exponential moving averages.
Note any intersections of the two averages. Whenever the 5-day moving average crosses above the 20-day moving average, this is a strong indication that the stock price will move up in the short term.
Whenever the 5-day crosses below the 20-day, there’s a good chance the stock price will continue dropping.
The 5-day/20-day EMA indicators are simple to plot on many free stock charts, and they are fairly reliable, with the following cautions.
They do not work well for low time frames, making them unusable for day trading. They suffer from “noise,” that is, frequent up and down spikes.
It is also not reliable for a sideways-trending stock, that is, stocks trading in a narrow range.
Moving Average Technical Analysis
Some traders like to use a 9-day EMA and a 13-day EMA for their comparisons.
When the 9-day EMA crosses above the 13-day EMA, it’s a possible entry signal for a bullish position.
The next plateau to watch is the 50-day EMA. If the stock breaks above it, look for a continuing trend.
There shouldn’t be much difference. The key is to plot a short-term line against a longer-term one.
Key Benchmarks: The 20-Day, 50-Day and 200-Day SMA
Swing trading requires a high degree of directional certainty before committing to a trade.
Look for strong relative strength. A stock’s 20-day, 50-day and 200-day simple moving averages help indicate longer trends.
Professional traders (institutional traders, hedge fund managers and the like) use these moving average key benchmarks.
At each of these three price points, the stock can change, as institutional traders either have a positive opinion on the stock, causing it to break above that mark, or they have a negative outlook, selling shares they own and causing the stock to pull back.
Heavy volume on such price moves reveals that big “institutions” are stepping in to buy or sell their shares, and this is an indication of which direction the stock will head in the short-term.
So, compare daily volume levels to confirm the strength of a trend.
Here are some general points to keep in mind:
• Only enter trades in the direction of the 20-day SMA.
• If the 20-day SMA is rising, it can serve as a support area.
• If the 20-day SMA is falling, it can serve as a resistance area.
Power Trend
Take a look at a stock’s 50-day exponential moving average (EMA) and the 100-day EMA. If the 50-day EMA is above the 100-day EMA, the stock is in an uptrend.
Conversely, if the 50-day EMA is below the 100-day EMA, the stock is in a downtrend.
The 200-day SMA Is Special
The 200-period simple moving average is the best indicator for insight into a stock or the overall market.
Many traders look at the 200-period moving average as a guidepost. It takes a long time to turn around.
Shorter time-frame moving averages, like the 13-period moving average, react quickly to price change.
When you get sustained trends, you’ll start to see them play out on the 200-period moving average over time.
You can identify reversal patterns by first figuring out the overriding trend.
Find a setup where the long-term trend remains intact, but the stock makes a retracement. A stock can dip down, but remain solidly above the 200-day SMA.
Since many traders use the 200-period moving average as their “go to” indicator for determining trends, you should pay attention to this line.
To be bullish, you want the stock to be trading above the 200-period moving average consistently.
Stocks that wiggle back and forth, crossing the 200-day moving average multiple times, aren’t necessarily in a bullish trend.
On the opposite side, the 200-day SMA line can become a resistance level. A stock that is in a long-term downtrend may spike at hit the 200-day level and then bounce back down.
So, bulls live above the 200-day SMA, and bears live below the 200-day SMA. The 200-day SMA can be used as an area of either support or resistance.
The 9, 21, 55 Exponential Moving Average Strategy
Some traders use the 9-day, 21-day and 55-day exponential moving averages to help determine a stock’s trend.
The 21-day EMA is a medium-term trend indicator, and the 55-day EMA is a long-term direction indicator (you can use the 50…it doesn’t matter).
• When the 55-day EMA line is below both the 9 and 21 lines, consider the trend to be up.
• When the 55 line is above both the 9 and 21 lines, consider the trend to be down.
• When the 9 is over the 21 while above 55, it’s an uptrend, and could be a signal to buy.
• When the 9 crosses below the 21 while already below the 55, it’s a downtrend signal to sell.
• When the 9 crosses over the 21, a short-term trend is turning against a long-term trend.
• When the 9 starts to pull away from the 21 and 55, consider momentum is entering the market.
• Seeing the 9 and 21 crossing and separating indicates a trending market.
• When the 9, 21 and 55 averages line up, a strong trend is in play. When the final cross takes place, look left for a swing high. If that swing high has been taken out, we can enter a trade on the close of the candlestick.
• If the swing high/low has not been taken out, buy on the close of the candlestick that breaks the high.
A Disadvantage of the Moving Average System
A disadvantage of the simple moving average approach is that it will allow an extreme high or extreme low spike to distort the true value of the stock, possibly giving false buy or sell signals.
Also, moving averages don’t perform well as trend indicators when a stock is choppy.
Additionally, trend reversals shown by a moving average will always lag behind the actual stock price change.
Moving Average Charts
Moving average charts give us an excellent visual picture of a stock price’s behavior.
Many times using simple indicators such as moving averages give us valuable insight in predicting a stock’s next move.
They are simple and easy to plot on even the most basic charting websites and charting software. Get familiar with using them.