How to Think About Moving Averages
Moving Averages are NOT Support or Resistance
One of the most common mistakes I see from people who are getting involved in trading is they think moving averages are support or resistance. This is not true.
Moving averages are just averages. They’re little squiggly lines in your chart that are composed of the average of the last however many bars the average calculation is measuring. For example, a 20 simple moving average is the average of the last 20 candles, or 20 periods, on the timeframe in which you are looking at.
While these moving averages are not support or resistance, they can be powerful tools if you use them correctly.
For my own trading, I look at an 8 and 21 EMA (exponential moving average). I also look at 20, 50, and 200 SMA (simple moving average) particularly on larger timeframes.
Equilibrium (8 / 21 Exponential Moving Average)
The space between the 8 and 21 EMA on a chart represents what I call technical equilibrium for the marketplace or that individual stock.
If a stock or market has moved far away from its 8 / 21 EMA, I would consider it to be extended from equilibrium. Understanding extension in markets is really important for evaluating risk and proper entry / exit spots.
If I’m buying a stock that’s extended, I’m going to have a worse risk-reward and a lower probability of success on the trade.
Pivot Points with Equilibrium (Higher Highs & Higher Lows)
I also utilize the 8 / 21 EMA to gauge where a stock might create a higher low. For example, a new pivot point to continue a trend.
When looking at an extended stock I think, “alright, the stock here is extended because a lot of momentum came in. I should be patient. Maybe a bull flag comes in, which would be more of a time correction that allows those moving averages to catch up.”
Once the moving averages have caught up to price, a trade in that name may have a better risk-reward and higher probability of success.
SMA (Simple Moving Average)
The simple moving averages I like are the 20, 50 and 200 SMA. I use them on larger time frame charts, such as daily and weekly charts.
For me, the most important part about the SMAs is the slope of the moving averages. Are they pointed higher, sideways, or lower? Are they crossing over each other? Or are they all telling me the exact same story, such as a rising 20 SMA above a rising 50 SMA above a rising 200 SMA?
The simple moving averages tell me the essence of the trend for that timeframe.
There are about 20 trading days in a typical month. If I’m looking at a 20 SMA on a daily chart, the direction of the slope of that moving average tells me the nature of the trend over the course of that last month.
The 50 SMA measures about the length of a quarter. I call it my intermediate time frame when looking at a daily chart.
The 200 SMA measures around a year. This is a really important moving average. It represents the long term essence of the trend for any stock or market.
Putting It All Together
If I’m looking at a rising 200 SMA, above a rising 50 SMA, above a rising 20 SMA, I know the essence of trend for every time frame is the same. All are trending higher.
Generally, if I’m going long an uptrending stock or market, I’ll have a higher probability of success than if I’m going long a stock trending downward or sideways.
Again, the key with these moving averages that people need to understand is they are not support and resistance levels. They are tools to help identify trends on different timeframes.
If you can learn to utilize moving averages, they can be very powerful for your trading. They can help you understand risk, reward, and probability of success for any trades you take.
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