They help me figure out:
1) Whether I want to be in a Portfolio Approach or Tactical Approach
2) Which stocks I want to be long or short
3) The strength of the current market trend
In fact, if I was a beginning trader looking to build my net worth, moving averages would be my #1 focus.
In this lesson, you're going to see the power of judging stocks and the market using the 8 & 21 day moving averages.
First, let's run through the basics so we're on the same page.
What Is a Moving Average?
A moving average is a stock's average price over a certain time period.
We're going to focus on the daily time frame this article.
A daily moving average is the average of a stock's daily closing price.
For example, the 50 day moving average is a stock's average closing price for the last 50 days.
Every day, the newest closing price in the moving averages replaces the oldest, which is why we call it 'moving' -- it's changing every day.
Here's a simple chart of Apple (AAPL) with its 50 day moving average.
Simple vs. Exponential Moving Averages
There are 2 types of moving averages -- simple and exponential.
A simple moving average is a straight average of the stock price.
An exponential moving average gives recent prices a bigger weight, so it does a better job of measuring recent momentum.
Going forward in this article, we will only use exponential moving averages.
The 8 day moving average will be shown in magenta.
And the 21 day moving average will be in red.
The Power of the 8 & 21 Day Moving Averages
Traders often ask me why I talk about the 8 & 21 day moving averages so much. Whether you see me on CNBC, Twitter, or the Virtual Trading Floor®, odds are you'll see me talking about them.
It's because these moving averages are the most accurate short-term road map I've found.
The 8 & 21 day moving averages are the most accurate short-term road map you can find - @reddogt3
A Chart's Worth a Thousand Words
Let's rewind the clock back to the Brexit in June 2016.
The day before the Brexit vote, the SPY hit $210.87.
And the day after the 'shocking' vote, it hit $188.65.
If you were focused on the headlines, you were feeling pretty scared:
A Statement of Strength
But let's extend the chart to see what actually happened.
As you can see, SPY started bouncing, and on June 30, 2016, it reclaimed the 8 & 21 day moving averages:
That's a statement of strength.
Because it meant momentum was shifting back to the upside.
And in this case, SPY briefly retested the 8 & 21 day moving averages before rallying above $219:
Price Action vs. Opinions
Everyone had an opinion over what the Brexit would mean.
But as you just saw in the charts, our opinions didn't matter as much as the market's.
When SPY reclaimed the 8 & 21 day moving averages with authority, it screamed that the bulls were retaking control.
And that's an important lesson for you: when a stock/index/ETF reclaims the 8 & 21 day moving averages with authority, PAY ATTENTION!
When a stock reclaims the 8 & 21 day MA's with authority, PAY ATTENTION! - @reddogt3
How I Use the 8 & 21 Day Moving Averages to Manage Market Exposure
You just saw how a big break above the 8 & 21 day moving averages can mean a big move higher.
Now let me show you how I use the 8 & 21 day moving averages to get less aggressive, or even bearish.
I have two primary approaches to the market: a Portfolio Approach and a Tactical Approach
When the SPY is trending above the 8 & 21 day moving averages, I am in a Portfolio Approach. I'll usually have 4-12 long positions in stocks showing relative strength, and occasionally even more.
When the SPY breaks the 8 & 21 day moving averages, I get in a Tactical Approach. I start taking profits, especially with weaker names, and I may even put on SPY or IWM hedges.
Here's a chart of the SPY with its 8 & 21 day moving averages:
As you can see, it reclaimed the 8 & 21 day moving averages with force.
After that happened, would it be better to be long multiple stocks? Or short the market?
Click here for the answer!
It would be better to be long, because the SPY made an aggressive move above the 8 & 21 day.
That's a sign the bulls were retaking control.
And as you can see a huge rally ensued!
P.S. That was the post-election rally, when the market skyrocketed after some initial volatility.
Like the Brexit, the post-election headlines were scary... but the price action was awfully bullish.
A Final Tip on Stock Selection
You've already learned how to use the 8 & 21 day moving averages to detect a change in trend, and how to use them for portfolio adjustments.
I'm going to give you a final lesson in handling momentum stocks... specifically, how not to get run over by one!
If you take one lesson away from this article, it's this: NEVER short a stock that shows momentum above the 8 & 21 day moving averages.
NEVER short a stock that shows momentum above the 8 & 21 day moving averages - @reddogt3
This is most true with controversial momentum names.
Take Tesla (TSLA).
In late 2016, the headlines were pretty rough:
But as you know, the price action is more important than the headlines.
Tesla reclaimed the 8 & 21 day moving averages, and rode the 8 day up from $190 to $287+.
No matter what the headlines and fundamentals are saying, you never want to short stocks like this.
I've seen a lot of traders fall in love with a fundamental thesis, but get burned when the stock goes parabolic.
Momentum is like gravity... you may not like it, but it's just reality.
And you can measure that reality with the 8 & 21 day moving averages.