Trading With Moving Averages

Moving Averages are another tool that can be used to help a short term trader define trend.  We have already discussed how trendlines are used and these can be used in a similar way.

I don't really want to get into how a moving average is calculated, because to be frank, its pretty boring.  All you need to understand is it takes the average price over a certain period of time and you come up with this line that moves up and down with price.  With moving averages we can help define trend.

The Most Common

The two that I find the most effective are the 20 day exponential moving average (EMA) and the 50 day (EMA).  One is faster responds quicker to price change and the other a little slower but doesn't whipsaw.

Three Ways to Approach Moving Averages

1. Slope of the Line
2. Cross Overs
3. Support and Resistance

Slope of Line

One of the quickest ways to asses the trend is the slope.  If the slope of both lines is positive it means the trend is up.  If the slope of the line is negative the trend is down.  If the faster moving average (the 20 EMA) begins to slope down.  An uptrend may begin to change.  If the faster ( 20 EMA) begins to slope up the down trend may begin to change.

Lets take a look





In each example it's pretty easy to see that with PHM the stock is in an uptrend and both moving averages are sloped upward.

In the RIMM example the down trend is pretty apparent because both moving averages are moving down together.

Cross Overs

Crossovers of moving averages are one way to tell if the trend is going to change.  When the 20 day EMA crosses below the 50 day EMA the trend may be changing from up to the beginning of a new down trend.   The chart below illustrates this:

 

When a cross on the moving averages occurs like this we can place a trade that is short the stock and if you are trading options you can buy puts.

Let look at another example




TJ Maxx has 3 bullish crossovers from Oct 2010 to October 2011.  This wis when a new up trend begins and as a short term trader these were perfect time because they ran up very quickly within the month.  Nice way to make some quick money.

One of the last ways we can use moving averages is as support or resistance.

Moving Average Support/Resistance

Moving averages are not magical lines that possess powers to turn price around.  The opposite is true they "bounce" as they often call it is more attributed to a price level where there is interest.  It just happens that a price might just "bounce" off it.

Here is the jist of how it works.  The 50 day EMA is support when the price is trading above it.  Meaning when the price pulls back it offers traders an entry signal



The other property is that when price dives below the 50 day EMA it can then become moving resistance.



So looking at this crucial moving averages are able to give short term traders a point at which we can find good entry into bearish or bullish trades.

The 200 day EMA

Most traders are familiar with this moving average.  It is the what I call the Bull/Bear divider.  It measures whether or not a stock is bullish or bearish.  Many stocks that break below the 200 day EMA will continue to be bearish and vice versa those stocks that hover and then move above the 200 day EMA will remain bullish for a fair amount of time.

Use this moving average on every chart you have because it offers one of the best reversal points in uptrends or downtrends.


The main idea here about moving averages is that they define certian areas as likely price levels where stocks may reverse.  We can use that to our advantage in up or down markets so pay attention to the trend and you can use moving averages to offer another way to confirm the price action or trend whether you are bearish or bullish.