How To Use Moving Averages

Moving averages are a useful tool for analyzing trends in a stock, commodity, or ETF.  They simply smooth out the day to day fluctuations in prices and give the analyst a cleaner view of the trend.  The number of days used in the moving average will determine the scope of the trend you are trying to identify.  Use shorter 10, 20, or 50 day moving averages for short term trend identification and longer 200 day moving averages for longer term trend identification.  You’ll notice in my basic chart setups I almost always have the 50 and 200 day moving averages displayed.  There are several different ways to use moving averages.  I’ve listed the most common below and I’ll make additions in time so be sure to check back often.

Trend Identification

The most common use for a moving average is simply to see which way the trend is.  If the moving average is sloping upwards the stock is in an uptrend.  When the moving average starts to roll over that means a new downtrend could be emerging. A sideways moving average would indicate a stock that is currently stuck in a trading range.  In the example below you can clearly see the transition from the upward sloping 50 day moving average to the downward slop.

Trend Identification

Resistance and Support

Another common use of moving averages is as a point of reference for resistance or support.  In a downtrending stock the moving average can act as resistance to any short pop that will naturally occur.  This is almost one of those things that becomes a self-fulfilling prophecy as so many people use the indicator in this way.  Take a look at the example below.  You can clearly see that each time the price moved up towards the 50 day moving average it was met with selling.  Similarly, the same type of action can be seen in an uptrend only you’ll have the stock bouncing up off of the moving average rather then below it.

Resistance and Support

Stop Losses

Another way I like to use moving average is to determine entry points for my stop losses.  The use of stop losses is controversial but for me it is a way to inject discipline into my trades and keeps me from losing more money then I’d like.  Take a look at the example below.  Towards the end of 2007 the S&P 500 made a decisive break of the 50 week moving average which had acted as support for several other corrections including the two corrections that took place in 2007.  At that point I liqiudated a large majority of my holdings and it proved to be a good decision.  Consequently, confirmation of this trend reversal came in may when the 50 week moving average which had once been support was now resistance and the market then proceeded to crash.

Stop Losses