Moving averages (MAs) identify support and resistance levels generated by price action over pre-defined cycle lengths, turning higher and lower in response to broad trends. Long-term averages turn more slowly than short-term averages, with slopes identifying technical conditions that raise or lower the odds for price penetration. Exponential moving averages (EMAs) change slopes more quickly than simple moving averages (SMAs) due to their faster construction.
Price pulling back to test a rising average from above is more likely to hold support than when testing a falling average. Price bouncing into a falling average from below is more likely to roll over than when testing a rising average. Multiple moving averages at different cycle lengths complicate these scenarios because some may be rising while others are falling.
- The moving average (MA) is a technical analysis tool that helps market participants contextualize price data by establishing a constantly updated average price for a financial vehicle.
- There is a complicated interrelationship between price, moving averages and the slopes that the moving averages use. A careful analysis will help demonstrate bearish or bullish tendencies.
- When the price is above rising long and short-term moving averages, it can be be beneficial to jump in on the long side. When the price is below falling long and short-term moving averages, the benefit may be on the short side.
Long-term averages change slope less frequently than short-term averages. For example, a 20-day MA can oscillate between rising and falling slopes dozens of times over a three-month period, while a 50-day MA may shift two or three times. Meanwhile, a 200-day MA may not change at all or shift higher or lower just a single time.
This slope relativity comes into play in chart analysis in two ways. First, a long-term average always exerts greater support or resistance than a short-term average. For example, support or resistance at a 200-day MA is harder to break than support or resistance at a 50-day MA. Second, rising and falling slopes add to or subtract from support or resistance, depending on the price's location relative to the averages.
In this hierarchy, a rising long-term average exerts greater support than a flat or falling average when the price is trading above the level while also generating increased support than a short-term rising or falling average. Conversely, a falling long-term average exerts greater resistance than a rising or flat average when the price is trading below that level while also generating greater resistance than a short-term rising or falling average.
Dow component The Coca-Cola Company (KO) bounces twice on top of the 200-day EMA during a 2017 uptrend and breaks support in early 2018, entering a major downtrend. Four bounces in the next three months reverse at the moving average, which rolls into a descending orientation. The 50-day EMA rolls over more quickly, generating five reversals during the same period. It crosses the 200-day EMA in March, printing a bearish death cross.
Adjusting Strategies to Slopes
Price above rising long- and short-term averages generate a bullish convergence that favors long-side strategies, with bigger positions and longer holding periods. This technical alignment is common in uptrends and bull markets. Price below rising long- and short-term averages generate a bullish divergence that favors dip-buying opportunities and value plays. Price trading above averages with opposing slopes signals conflict, with a rising long-term average supporting long-side plays while a falling slope points to a higher-risk environment.
Price below falling long- and short-term averages generates a bearish convergence that adds power to short sale strategies, encouraging bigger positions and longer holding periods. This technical alignment is common in downtrends and bear markets. Price above falling long- and short-term averages generates a bearish divergence that favors profit taking and short selling. Price trading below averages with opposing slopes signals conflict, with a falling long-term average supporting short side plays while a rising slope warns of an impending bottom.
These scenarios cover just a small portion of the complex interrelationships between price, moving averages and slope. Conflicts should be welcomed because interweaving price structures create powerful engines for short- and long-term trading opportunities. However, watch out when moving averages ease into horizontal orientation and converge, and the price starts to oscillate across those narrow levels. This mixed action points to high noise levels that can signal long periods of weak opportunity:cost.
Moving averages ease into horizontal trajectories in sideways markets, lowering their value in trade and investment decision making. Dow component McDonald's Corporation (MCD) sells off at the start of 2018 and spends the next four months grinding sideways in a choppy pattern. It crisscrosses the 200-day EMA more than 30 times during this period, issuing multiple waves of false signals. The 50-day EMA goes horizontal as well while price crosses its boundaries more than a dozen times.
What Are the Most Commonly-Used Moving Averages?
The 50-day, 100-day and 200-day moving averages are most-commonly used by investors to identify relevant, long-term support, resistance levels and broader trends.
What Are the Different Kinds of Moving Averages?
A moving average, also called a moving mean or rolling mean, can include variations. The most common of which are: simple, cumulative, and weighted moving average.
What Are Moving Averages Used For?
Moving Averages are used to determine the direction of the price of a stock or other financial vehicle or to determine what its support and resistance levels are. It is based on past prices and is therefore seen as a lagging, although
still relevant indicator.
The Bottom Line
Get aggressive on the long side when the price is above rising long and short-term moving averages. Get aggressive on the short side when the price is below falling short and long-term moving averages. Get defensive when slopes don't match, or when the price is trading below rising averages or above falling averages.