By Casey Murphy, Senior Analyst ChartAdvisor.com
Some of the primary functions of a moving average are to identify trends and reversals, measure the strength of an asset's momentum and determine potential areas where an asset will find support or resistance. In this section we will point out how different time periods can monitor momentum and how moving averages can be beneficial in setting stop-losses. Furthermore, we will address some of the capabilities and limitations of moving averages that one should consider when using them as part of a trading routine.
Identifying trends is one of the key functions of moving averages, which are used by most traders who seek to "make the trend their friend". Moving averages are lagging indicators, which means that they do not predict new trends, but confirm trends once they have been established. As you can see in Figure 1, a stock is deemed to be in an uptrend when the price is above a moving average and the average is sloping upward. Conversely, a trader will use a price below a downward sloping average to confirm a downtrend. Many traders will only consider holding a long position in an asset when the price is trading above a moving average. This simple rule can help ensure that the trend works in the traders' favor.
Many beginner traders ask how it is possible to measure momentum and how moving averages can be used to tackle such a feat. The simple answer is to pay close attention to the time periods used in creating the average, as each time period can provide valuable insight into different types of momentum. In general, short-term momentum can be gauged by looking at moving averages that focus on time periods of 20 days or less. Looking at moving averages that are created with a period of 20 to 100 days is generally regarded as a good measure of medium-term momentum. Finally, any moving average that uses 100 days or more in the calculation can be used as a measure of long-term momentum. Common sense should tell you that a 15-day moving average is a more appropriate measure of short-term momentum than a 200-day moving average.
One of the best methods to determine the strength and direction of an asset's momentum is to place three moving averages onto a chart and then pay close attention to how they stack up in relation to one another. The three moving averages that are generally used have varying time frames in an attempt to represent short-term, medium-term and long-term price movements. In Figure 2, strong upward momentum is seen when shorter-term averages are located above longer-term averages and the two averages are diverging. Conversely, when the shorter-term averages are located below the longer-term averages, the momentum is in the downward direction.
Another common use of moving averages is in determining potential price supports. It does not take much experience in dealing with moving averages to notice that the falling price of an asset will often stop and reverse direction at the same level as an important average. For example, in Figure 3 you can see that the 200-day moving average was able to prop up the price of the stock after it fell from its high near $32. Many traders will anticipate a bounce off of major moving averages and will use other technical indicators as confirmation of the expected move.
Once the price of an asset falls below an influential level of support, such as the 200-day moving average, it is not uncommon to see the average act as a strong barrier that prevents investors from pushing the price back above that average. As you can see from the chart below, this resistance is often used by traders as a sign to take profits or to close out any existing long positions. Many short sellers will also use these averages as entry points because the price often bounces off the resistance and continues its move lower. If you are an investor who is holding a long position in an asset that is trading below major moving averages, it may be in your best interest to watch these levels closely because they can greatly affect the value of your investment.
The support and resistance characteristics of moving averages make them a great tool for managing risk. The ability of moving averages to identify strategic places to set stop-loss orders allows traders to cut off losing positions before they can grow any larger. As you can see in Figure 5, traders who hold a long position in a stock and set their stop-loss orders below influential averages can save themselves a lot of money. Using moving averages to set stop-loss orders is key to any successful trading strategy.
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