Use moving averages to spot trading signals

 

Answer: (not surprisingly!) An average that moves! To calculate a moving average, we first take the average price of the last X number of data points, where 'X' is the duration of the 'lookback period', for example 10 days. As we move forward in time, we add the newest data point to the calculation, and drop off the oldest data point, so that we always calculate the average over a consistent lookback period. As we create more and more data points, we can join them together to generate a line which represents the rolling, or 'moving' average over the lookback period.
 

Statisticians use averages to reduce noise in a data sample. An average represents the central value of a data sample. A moving average allows the investor to smooth out short term fluctuations over the lookback period, and by doing so, to focus on the underlying trend in the data. As investors, we typically use the closing price of a security for a chosen periodicity to create a moving average (e.g. hourly, daily, weekly, monthly etc.), but we could also use any other commonly obtained data like the high or the low, or even the volume of the security traded.
 

Indeed, moving averages are used as a proxy for the underlying trend in a stock's price over a specific lookback period. So for example, if we wanted to measure a stock's trend over say one month, we could use a lookback period of 21 days for our moving average (don't forget there are about 21 trading days in a month once you adjust for weekends and public holidays).

This is one of the key strengths of using moving averages in our technical analysis, that is, the ability to tailor the moving average exactly to our needs. Shorter term traders are best suited to using shorter lookback periods, for example, 5, 10, or up to 21 periods (1 week, 2 weeks, and up to 1 month). Medium term traders are best suited to longer lookback periods, for example, 42, 63 or up to 126 periods (2 months, 3 months, and up to 6 months). Longer term investors may consider using lookback periods of 126, 252, or beyond (6 months, 1 year and greater).



Chart 1: Moving average basics, various simple moving average lookback periods
 

As well as deciding on the lookback period of a moving average, investors are also faced with a wide array of choices for its calculation method. The method described above, where each data point in the lookback period has equal weighting, is generally referred to as a 'simple moving average' or SMA. There are a range of other calculation methods where more recent data in the lookback period is given a greater weighting in the final value of the moving average than earlier data.

This is generally favourable as moving averages are a 'lagging indicator', that is, their current value is based upon historical data. So, as traders who desire our moving averages to strip out the worst of the volatility in the lookback period, but still be as responsive as possible to changes in the underlying trend, some method of weighting towards recent data is preferred. Calculation methods for moving averages commonly found on charting software include: simple, weighted, exponential, double exponential, triple exponential, and linear regression. 



Chart 2: Calculation methods for moving averages, SMA versus EMA
 

Our preferred method of calculation is the exponential moving average or EMA. In the chart above, note how much more responsive the 42 period EMA (red line) is to changes in the stock's price compared to the 42 period SMA (blue line). Remember, the direction of a moving average indicates the direction of the trend in the stock's price during the chosen lookback period. As a result, we could use our preferred moving average to signal an entry point based upon the establishment of an uptrend, and an exit point based upon the subsequent establishment of a downtrend.

Observe in January 2021 how the 2-month trend as proxied by the 42 EMA changes from down to up earlier than compared to the 42 SMA. Thus, the 42 EMA provides an earlier entry signal than the 42 SMA. Similarly, observe in early March 2021 how the direction of the 42 EMA changes from up to down earlier than compared to the 42 SMA, and in doing so, signals the end of the 2-month uptrend. Once again, the 42 EMA has provided an earlier trade signal (this time an exit). Note also how the 42 SMA still hasn't registered the change to downtrend by the end of the data sample in April!

Apart from simply checking and trading in the direction of the trend, there are two other useful moving average signal systems investors can use to spot trading opportunities. The first system involves monitoring when the price breaks above or below your chosen moving average. When the price closes above a moving average, you're on alert that the trend the moving average is measuring is potentially turning up. Conversely, when the price closes below a moving average, you're on alert that the trend the moving average is measuring is potentially turning down.



Chart 3: Trading signals using moving averages, price vs moving average signals 

In the chart above, a 21 EMA (red line) and a 42 EMA (blue line) are used to measure the trend in Zip Co. over 1-month and 2-months respectively. Note how the shorter term trader using the 21 EMA system generates more trading signals than the longer term trader using the 42 EMA system. We say that shorter term moving averages are 'more responsive' to trend changes than longer term moving averages. This can be beneficial in getting us into and out of a stock earlier, but it can also trigger a number of 'false signals' that enter/exit quicker than we would like. Apply a range of moving averages to a stock you're interested in and try to work out which lookback period delivers the best balance of responsiveness and accuracy you require.

The second system involves using a combination of moving averages with shorter and longer lookback periods. As we know, shorter moving averages respond faster to trend changes. When the shorter duration moving average crosses above the longer duration moving average, it indicates an uptrend has commenced. Investors may use this event as a potential buy signal. Conversely, when the shorter duration moving average crosses below the longer duration moving average, this indicates a downtrend has commenced. Investors may use this event as a potential sell signal. 



Chart 4: Trading signals using moving averages, moving average crossover signals

In the chart above, a 10 EMA (red line) and a 21 EMA (blue line) are used to measure the trend in Zip Co. over 2-weeks and 1-month respectively. A potential buy signal is generated when the 10 EMA crosses above the 21 EMA. A potential sell signal is generated when the 10 EMA crosses below the 21 EMA. A trader may choose to enter/exit at the open of the trading session immediately after a signal is observed, or they may prefer to experiment with a number of entry and exit options. For example, they might choose to set a stop loss just below either the shorter or longer term EMA as an alternative exit option.
 

This valuable characteristic of moving averages is far less well-known. You can also use moving averages to predict where the price of a security might bounce higher from (support), and where the price of a security might bounce lower from (resistance). Because moving averages are just that, moving, we refer to them as 'dynamic' support and resistance. This contrasts with regular support and resistance points from the past such as major peaks and major troughs, which we typically refer to as 'static' support and resistance (i.e., they'll never change!).

There's no official reason why moving averages should offer dynamic support and resistance, but depending on the security in question, and the moving averages chosen, one will regularly observe the phenomena. It might take a little time to find which moving averages work best for the security you're interested in, but it is worth investigating this method.

You will find that the price consistently reacts around the chosen moving averages. Note however, this method is best used with other confirmatory technical analysis tools such as Price Action and Japanese Candlesticks.  Don't automatically assume a dynamic support or resistance zone will hold - it is at best indicative only. Any support and resistance zone (whether static or dynamic) requires confirmation from other technical methods to generate a reliable trading signals.



Chart 5: Dynamic support and resistance using moving averages
 

You should now be able to select the appropriate moving averages for your trading style, and use them to determine the direction of the trend for any stock you choose. On this point there should be no confusion: the direction of a trend defined using the methodologies described here is unequivocal. This is the beauty of moving averages! They provide us with clear cut trading signals on any security we wish to analyse. In addition, they regularly supply us with useful information on possible dynamic support and resistance zones.

Note however, moving averages are just one tool in our extensive technical analysis toolbox! Be sure to use moving averages in combination with other technical indicators, particularly static Support and Resistance, Price Action, and Japanese Candlesticks, and they should prove to be a reliable and profitable trading tool.