The 20-day moving average is a commonly used value for short- to intermediate-term trends because it represents approximately a full month's worth of trading. In a sideways market, prices will usually fluctuate above and below the 20-day moving average. When a stock is in a trend, however, it will usually use have an impulsive move away from the average in the direction of the longer trend, and then regress to the average in a corrective manner. The 20-day moving average also lets you know how a market is trending by how steep the slope is.
Oftentimes, a trader can find a low-risk opportunity when a stock makes one of these counter-trend moves toward its 20-day moving average. Because the move is counter to the overall trend, the 20-day moving average often will act as support or resistance on these pullbacks. Astute traders can wait for reversal signals there, and have well-defined risk parameters.
Apollo Group (Nasdaq:APOL) is a good example of a stock showing a reversal pattern after regressing to a declining 20-day moving average. Notice the shooting star after trading above the average in yesterday's session. Another clue a trader can look for is whether the 20-day moving average is aligned with a longer-term moving average such as the 50- or 200-day moving average. Both the 20- and 50-day moving averages are trending lower in APOL, increasing the chances that APOL will reverse at resistance.
The Nasdaq OMX Group (Nasdaq:NDAQ) is also showing a shooting star reversal pattern at its declining 20-day moving average. While the moving average isn't at a severe slope, both the 20- and 50-day moving averages have been bearishly aligned for months. This helps identify the trend as lower, despite the choppy and noisy price patterns on the chart. (For more, see Star Formations Spotlight Luminary Trades.)
Luminex Corporation (Nasdaq:LMNX) is another example where both moving averages are aligned in a bearish posture and LMNX appears to be backing away from both the 20- and 50-day moving averages. The 50-day moving average has held the last few rally attempts and the bearish candle that formed yesterday hints at more of the same. (For more, see our Moving Average Tutorial.)
Compass Minerals (NYSE:CMP) is an example of how a moving average can turn into resistance after a period of consolidation. Notice how CMP was alternating or oscillating above and below the 20- and 50-day moving averages as it consolidated in a triangle chart pattern. Once it broke down, the faster moving average crossed over the slower one, and it held CMP on the first bounce attempt. CMP appears to heading toward a lower low from here, and the moving averages are starting to take on a more severe slope lower.
Often the price pattern on a chart will be very noisy and make it difficult to determine the direction of the trend. By paying attention to the moving averages and their relation to each other and price, we can often get a clearer picture of the present trend. Some traders will even remove price from the chart and simply look at the moving averages to get a sense of the trend and its momentum. Each of the stocks above appears to be reversing after a corrective bounce.
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At the time of writing Joey Fundora did not own shares in any of the companies mentioned in this article.