An average is designed to give the user a fair representation of the scope or quality of a larger group of numbers. A college graduate will be interested in the average starting salary of a job in his or her particular industry. A general manager in baseball will be interested in the batting average of a particular player. In reality, the college graduate may do much better or worse than his peers. The same is true for a general manager who generally underpays for young players on the rise and overpays for stars past their prime.
When it comes to financial markets, moving averages are used to provide a fair representation of recent price action and help traders anticipate what may come. However, they are still best used as a guide. There are many pieces to the puzzle when it comes to analyzing a price chart, and it is important to understand what moving averages mean and how they are used in gauging market activity when you consider which piece of the puzzle they represent.
Here, we’ll look at some common applications of moving averages and advance to how they work with other techniques to provide a clearer overall picture of market action.
USING AVERAGES TOGETHER
Among moving averages, all traders have their favorites. However, in terms of popularity, it’s hard to argue the widespread use of the 50- and 200-day moving averages.
“Before the fall” (above) shows a chart of action in the Dow Jones Industrial Average. During a good bull move, price action will generally pause or pullback to the 50-day moving average. It may do this several times in the course of the move. However, there comes a point where the 50-day is violated and putting other technical factors aside, this is an important clue to a change in trend. When this happens, the correction is larger than a pause in the uptrend.
On the other hand, we don’t know what may happen in the larger picture. After extended bull or bear markets, traders and technicians alike are looking to see if the 50-day will cross the 200-day. When this cross materializes, it usually means a market is confirming a larger degree trend change. Many times, this crossover will occur close to an important universal time window.
In the recent case of the Dow, this cross happened at the Fibonacci-significant 55 days off the top. This crossover doesn’t guarantee a larger degree change, but it does increase the prospects of one. Because it is not a guarantee, though, we must consider these moving average crossovers a guide. However, when they materialize at important time windows, probabilities of a turn increase.
After the low is established and price action moves to the technical-bounce phase off the low, the moving average becomes a target for the termination of a bounce. Many times, the moving average will line up near an important Fibonacci retracement level. In this case, the 50-day moving average is retested in March when it is close to the 38% retracement. It is important for traders to recognize that these points on the chart act as magnets. If price action is going to fail, the higher probability outcome is the failure will materialize at the 50-day or even the 200-day.
“How sweet it isn’t” (above) shows another example of how an average keyed in off an important Fibonacci level. The first test comes after a big move at the 15 level where the 50-day moving average is close to the 38% retracement of this entire leg. After an extended move, it may take multiple tests before the failure materializes. In this case, price action tests the line for seven trading sessions before closing below it.
Once the 50-day is broken, odds increase that either the 61% retracement or 200-day moving average will be tested. On daily charts, these two markers are close and create more of a support zone as opposed to a line in the sand.
The initial test of the 200-day leaves a tail below the 61% level at 13.70 only to come close to the 200-day before closing back above the retracement line. From there, the 200-day is tested again and it holds. What that means for the time being is this particular market is tracing out an intermediate-level correction as it successfully defends the 200-day. It is only when the next failure at the 50-day kicks in does the 200-day ultimately fail on the last turn down.
Once price action holds at the 200-day and the next test of the 50-day happens by default, former support (the initial test of the 50-day at 15) acts as resistance. If the 50-day is taken out at this point, chances increase for a new bull leg. It is this combination of the moving average and potential flip in polarity that makes this a good shorting opportunity. This is one of those areas on the chart that acts as a magnet to the price action. Finally, once the 200-day breaks, prices go appreciably lower (not shown on this chart).
Another important characteristic of moving averages is they serve as points where benign pullbacks compete for buyers to establish initial positions or add to profitable positions.
Keep in mind, the better these charts are organized and respect the moving averages, the greater the underlying strength of a particular market. “Sox rocks” depicts price action in the Philadelphia Exchanges Semiconductor index (SOX) from the 2003-04 rally after the bear market bottom was retested.
The 50-day is tested numerous times but never breaks for more than a day or two, making each test an opportunity to buy the dip. The best buying opportunities materialize when the test of the line clusters with a universal time window. The cluster with the time window is not a requirement but it certainly helps when you’re looking for a reason to have conviction to stay with a move. On this chart, two of the better opportunities materialized when price action was 127 and 161 days respectively off the low. While it is not shown on this chart, this leg did complete when it hit the 233-day window off the 2003 low.
Moving averages have a slightly different purpose when it comes to individual stocks. When tracking indexes, it is sufficient to use the 50- and 200-day, at least on a daily time frame. When trading stocks, a 20-day moving average comes into play because the 50-day is generally too far distant to keep a stop unless the time frame is extremely long term. Consequently, many strongly trending stocks will stay in a channel line and only pull back to the 20-day.
This condition will not be the case in stocks that don’t have good relative strength, but those stocks don’t make great moves anyway. The final case study demonstrates these principles in a recent bull trend in Chevron Texaco (CVX). The first chart in “Slick move” demonstrates the early part of the move before the trend is well defined. Even though there is an early shakeout, the 20-day contains most of the price action. The 50-day moving average is less important but serves as a warning sign of a bigger correction when violated. The 200-day moving average will be important, as it will highlight the end of many corrections.
The second chart is the best part of the move. The green line is the 20-day; it does an excellent job of containing the price action. It serves as a point of entry for those looking to buy the dip. This is classic action of a strongly trending stock. Again, the 200-day marks an end to a correction in the $82-$84 price range near the 38% retracement level.
It is important to note when Fibonacci retracements come into play. Because strongly trending stocks don’t have many corrections, Fibonacci retracements are less important in the near term. However, when real corrections finally materialize, the 200-day will generally line up close to an important Fibonacci level. These Fibonacci levels are slightly different for stocks and the major indexes.
The time cycle also will be a secondary factor during a strong move. The time windows will remain in the background but still create an important high that halts this leg in the 144-day window. The 20-period average works in corrections as it contains the action from the September high to the November low.
While moving averages should be used as a guide, traders can come to anticipate higher probability tendencies. We can anticipate pullbacks or spikes to complete at or near the 50-day. We can anticipate a larger degree of trend change when the 50-day crosses over the 200-day. The size of the moving average also helps traders to understand the magnitude of the trend. Recently, the Nasdaq made a low near the 200-week moving average with the S&P 500 just below it.
It is the larger weekly line that determines whether we are experiencing a run-of-the-mill intermediate-term correction or a bear market that can last a year or more. Throughout the course of this decade, the 200-week average was taken out several times only to recover within a handful of weeks. After a violation, it is normal for price action to come back and retest the line. A failure would mean former support had turned into resistance and greatly increase the probability of a long-term bear market.
Moving averages aren’t infallible; they can and will be broken in a whipsaw market. Traders must be aware of other technical conditions and understand that averages are a general gauge more than a specific measure.
Jeff Greenblatt is the director of Lucas Wave International. He is the author of “Breakthrough Strategies for Predicting Any Market,” a Marketplace book. He can be reached via www.lucaswaveinternational.com or firstname.lastname@example.org .