Reliability of Moving Averages
Moving averages are used by both traders and investors of all experience levels.
Anyone who knows about market psychology will know that is the reason why moving averages are so reliable for trading. Any trading tool or trading strategy that is well known and commonly used will be very reliable.
Think of it this way: if every trader in the world was told that a trade would net a 100% return every time a stock’s volume was twice the 10-day average, what do you think would happen when a stock’s volume was twice the 10-day average?
Yup! You guessed it- the stock would likely hit or come close to netting a 100% return.
This principle applies to using moving averages. It works because moving averages have been around for decades and they are one of the first things new traders and investors are taught.
Commonly Used Moving Averages
Moving averages can be used in different ways and on all time frames. Investors use them to make buy and sell decisions for long-term positions. Swing traders use them to make trading decisions in a brief period of time. Day traders use them to make same day trades.
The length of the moving average you choose should be based on how well it fits the chart for the stock your are analyzing. You should play with the length of the moving average until it fits nicely. These are the most commonly used moving averages that fit most charts well: the 20-day, the 50-day, the 100-day, and the 200-day.
Although you can use them on any time frame, they are most reliable on higher time frames. This is true with almost any trading indicator. It is because shorter time frames are often choppy and contain too much noise. For example, one large trade on a shorter time frame can skew the data, which leads to false signals.
The moving average you use should be based on your goals. Traders looking for quick signals on smaller time frames would want to use a moving average with a period of 50 or less. Traders looking for longer term trades would want to use a moving average with a period of 50 or more.
Moving Average as a Buy Indicator
Using Moving Averages as Support
Rather than using static forms of support and resistance, traders like to use moving averages to identify dynamic levels of support and resistance. Many traders use moving averages as dynamic support and resistance because the price will often respect the moving average.
The longer term moving averages such as the 50-day, 100-day, and 200-day tend to act as support levels. When the price gets close to the moving average, or falls slightly below, it will often bounce back and continue its upward trend.
Traders and investors will use this as a buying signal. Any time the price is close to the moving average, it would be considered a good point to buy. The price could be slightly above, below, or right on the moving average.
Example
Let’s take a look at an example. Here is the 5-minute chart of Apple Inc. (AAPL) with the 50-day SMA.
Your entry point could have been where the trend began changing. Ideally, you would’ve entered the trade when you saw the 50-SMA begin to curl up on the 9th. You could have remained in the trade until you noticed the double-top resistance on the 11th. Another signal to exit the trade came when the 50-SMA began to flatten out and curl downward.
As you can see, every time the price came close to the 50-SMA, or even fell slightly below, the price bounced back and continued the upward trend. You could have entered a trade at any one of these areas and made a decent profit.
If you caught this trade from beginning to end with options, you could have easily had a 100%+ return.
Keep in mind that a moving average will not always act as support. This dynamic support acts the same way as a static support level. Sometimes the price will fall below the moving average and then it will become a point of resistance. A break of support could very well signal a trend reversal.
It is best to use this moving average strategy in conjunction with other trading tools and indicators.
Identifying Bullish Trend Changes with Cross-Overs
Another use of moving averages is to identify trend reversals. That way you can ride a new trend for maximum profit. In order to use this strategy, you will need to have at least two moving averages on your chart.
Popular combinations to have on your chart are the 20-day and the 50-day, the 50-day and the 100-day, or the 50-day and the 200-day.
This strategy is very simple and straight forward- you buy when the shorter term moving average crosses above the longer term moving average. For example, you would buy when the 50-day crosses over the 200-day.
Examples of the Bullish Cross-Over Signal
Let’s take a look at a couple of bullish cross-overs and the results of them.
AAPL, 5-Minute Chart
In this example, on the 5-minute chart of AAPL, you will see that there was a bullish cross-over around closing on the 17th. You could have had two different entry points for this trade. The first entry could have been when you saw the 50-SMA begin to curl up. You could have also entered when you saw the 50-SMA cross over the 200-SMA, creating a bullish cross-over signal.
From that point, you could have rode the new trend in its entirety. You could have exited your trade at two different points. The first exit could have been when you noticed the two moving averages beginning to converge around 1pm on the 20th. You could have also exited around 12pm on the 21st when you the price broke below both the 50-SMA and the 200-SMA.
Riding this trend from 304 to 317 with options would have a netted you a huge return for a four-day trade.
TSLA, 1-Day Chart
This example with the 1-day chart of TSLA is hands-down my favorite depiction of how profitable this moving average strategy is.
Like the previous example, this one would have offered you two key entry points. The first entry could have been when you saw the 50-SMA begin to curl up. You could have also entered when you saw the 50-SMA cross over the 200-SMA, creating a bullish cross-over signal.
If you entered a trade at any one of these entry points, you would have entered your position in the beginning of November when the share price was around 350. Being that there were no clear signals to exit, you would still be in the trade as of May 2nd. On May 2nd, the share price was a 990!
This trade would have yielded you a 182% return with shares. That means you would have almost tripled your money! Now imagine that return if you were trading options…. this trade with the moving average cross-over would have yielded you close to a 1000% return!
Moving Averages as a Sell Indicator
Using Moving Averages as Resistance
Using moving averages as resistance is the exact opposite of using them as support.
The longer term moving averages such as the 50-day, 100-day, and 200-day tend to act as resistance when the price is below them. When the price gets close to the moving average, or rises slightly above, it will often crash back down and continue its downward trend.
Traders and investors will use this as a signal to short. Any time the price is close to the moving average would be considered a good point to short. The price could be slightly above, below, or right on the moving average.
Example
Let’s take a look at an example. Here is the 1-day chart of AAPL Inc. (AAPL) with the 50-day SMA.
You could have entered a short position at 4 different points in this example. The first short entry could have been in the beginning of November when the 50-SMA began to curl downward, signaling a bearish trend was beginning. The other 3 short entries could have been when the price rose to touch the 50-SMA in December, January, and April.
Your exit point, or area to cover your short position, would have been when the 50-SMA began to flatten out in May.
As you can see, every time the price came close to the 50-SMA, or even rose slightly above, the price crashed back down and continued the downward trend. You could have entered a trade at any one of these areas and made a decent profit.
Entering your short position at the first short signal at 96 in November 2012 and covering at 68 in May 2013 would have netted you a 29% profit. Being in this same position with options would have netted you a 100%+ return!
Keep in mind that a moving average will not always act as resistance. This dynamic resistance acts the same way as a static resistance level. Sometimes the price will rise above the moving average and then it will become a support level. A break of resistance could very well signal a trend reversal.
Again, it is best to use this moving average strategy in conjunction with other trading tools and indicators.
Identifying Bearish Trend Changes with Cross-Overs
You can identify a bearish trend change with a cross-over by using the opposite of the directions given for identifying a bullish trend change.
You short when the shorter term moving average crosses below the longer term moving average. For example, you would short when the 50-day crosses below the 200-day.
Examples
Let’s take a look of a couple of bearish cross-overs and the results of them.
NFLX, 5-Minute Chart
In this example, on the 5-minute chart of NFLX, you will see that there was a bearish cross-over around 10am on the 20th. You could have had two different entry points for this trade. The first entry could have been when you saw the 50-SMA begin to curl down. You could have also entered when you saw the 50-SMA cross below the 200-SMA, creating a bearish cross-over signal.
From that point, you could have rode the new trend in its entirety. You could have exited your trade at two different points. The first exit could have been when you noticed the 50-SMA beginning to curl upward around 1pm on the 27th. You could have also exited around 12pm on the 28th when the 50-SMA crossed above the 200-SMA, creating a bullish cross-over signal.
Riding this trend from 450 to 312 with options would have a netted you a huge return for an eight-day trade.
NVDA, 1-Hour Chart
In this example, on the 1-hour chart of NFLX, you will see that there was a bearish cross-over around May 2nd. You could have had two different entry points for this trade. The first entry could have been when you saw the 50-SMA begin to curl down at the end of April. You could have also entered when you saw the 50-SMA cross below the 200-SMA, creating a bearish cross-over signal.
From that point, you could have rode the entire bearish trend. You could have exited your trade at two different points. The first exit could have been when you noticed the 50-SMA beginning to curl upward around June 9th . You could have also exited around June 22nd when the 50-SMA crossed above the 200-SMA, creating a bullish cross-over signal.
Riding this trend from 170 to 140 with options would have a netted you a huge return for a two-month trade.
Final Words and a Bit of Caution
Moving averages can give fantastic signals to traders than can yield massive profits. They are great for identifying trends and knowing when it is wise to buy or sell.
The biggest issue with moving averages is that they are lagging indicators. This means that they move and adjust to price movements slowly because they rely on past data to create signals.
Having a lagging indicator can lead to false trading signals because they do not have any real predictive power. Rather, they give suggestions on how future price action will behave based on how it behaved in the past.
Overall, moving averages have been used by investors and traders for decades and they have been proven to be a very reliable indicator. Go ahead and give it a try! It will can help improve your trading significantly.
Do you use moving averages while trading? What is your favorite strategies? Do you use different strategies that work well? Make sure to let me know!