As with all technical indicators, moving averages are just tools chartists use to figure out what they need to do in the markets. Notice I said they are figuring out their own actions, not divining where the market is going. Of course, the two are related but that is not the point.
What is the point is that pundits and journalists like to report when the market breaks one of the more widely followed moving averages. In this edition of Unmasking I am going to take a look at what a move through an average - or a "crossover" - really means.
Let's start with just what a moving average is. If you want the full definition feel free to fire up the google, the bing or even (shudder) the yahoo. And if you know what a moving average is, feel free to skip the next two paragraphs.
A moving average, or average, is just an mean price over a certain period of time. A 50-day average is the sum of all prices - usually the close prices - divided by 50. Easy peasy. Since the calculation is redone fresh each period, the value window of data "moves" over time. Get it? Moving average!
Yes, we can change the span, period, input type and even the weighting of the calculation using any number of oddball formulas but again, if you want to learn about that, it's back to the google for you.
So what is the big deal with these things? Do they create trade triggers? Which ones do we use?
To answer the last two questions: maybe and whatever floats your boat. Yeah, not much help but these are answers you need to develop on your own. I'll just tell you what I do with them.
And to the first question, the big deal is that they help us see the forest for the trees. They smooth out jumpy price action to let you see the major and minor trends. You change the parameters depending on what you are trying to do.
You do realize that the government actually uses a moving average on some of its big monthly economic reports, right? Why? They say it smooths things out. Score one for the chartists.
You can use averages in pairs or even triplets, garnering insights as the averages dance around each other and with the price plot. But let's KISS (keep it simple, schmegegge).
Let's talk about the 50-day moving average. Yesterday, August 10, 2017, the S&P 500 and Nasdaq both closed below their 50-day averages for the first time since July (June for the Naz). The financial headlines were quick to point that out and with the news of the day - a potential nuke crisis in North Korea - boy did they make a big deal. Gotta build the click through count.
Chicken Little was ready to sell everything and head for the hills. Now, can we take a peak at the headline from July 6, 2017 when the S&P 500 last closed below this red line in the sand?
July 6 - Nasdaq challenges major support amid geopolitical tensions, S&P 500 nails 50-day averageIn the words of that famous portfolio manager Homer Simpson, "Doh!"
Six days later, the Spoos reached another new all-time high. Talk about a crappy sell signal!
Let's look at the charts. As you can see, price action violated the average on four separate occasions before the current event since the November pre-election low. The 50-day average did not deliver a successful sell signal one time. None. Zilch.
That does not mean that a drop below the average is always meaningless but I'd rather look for something more reliable, such as a support break, to tell me to sell. Rather, I'd use breaks of the average to set up or confirm other signals.
So again, what is the point? The point is that averages help us figure out the trend. Just look at their name - average. Let's expand the chart all the way back to the start of the major rally in early 2016.
I added the trend channel with a little technician's license to make the upper line more meaningful. That means it touches price action more times.
Look at the 50-day average. It more or less runs through the middle of the channel. Price goes above and below it yet it still was a bull market. The average itself spent most of the time rising.
The next question about that time when it was not rising naturally will be, "How do you know it will go back up?" Well, you don't but there are other tools to use, such as the popular 200-day average and any number of indicators.
The point is that in a bull market being above the average is good but being below it is not necessarily bad. In a bear market, being below is good (for the bears) but being above is not necessarily bad (for the bears).
So, slap on your averages, short-, medium- or long-term, simple, exponential or VIDYA, and find out what the current trend is. However, selling just because price dipped below your average is not always a good idea.