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Keeping Your Trends Close with Moving Average Crossovers

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April 13, 2014

Whether you’re on Hawaii’s North Shore, New York’s trading floor or somewhere in between, failure to recognize the right wave at the right time can get you soaked. Before you’re ready to “shred” the market, learn what to watch for.

Surfers & traders share at least a few common traits (if you fall into both categories, we salute you). For either pursuit, capitalizing on that big “wave”—knowing when to get in and get out—is crucial to your strategy.

Trends and markets are inseparable. Whether we’re talking about a blue-chip stock or a T-bone steak, the price of said item has likely not been sitting still—it’s been doing something over the course of time.

For our purposes, a trend can be defined simply as the general direction of a market over the short, immediate and long term. As in the ocean, markets have both tiny and huge waves, and some in between. A technical tool known as a simple moving average crossover can help you identify the lion’s share of a trend.

Some stock moves are short-lived, while others last for weeks, months, or even years. If the trend is indeed your friend, to cite an ancient trading axiom, how can a moving average crossover system help? Start with two questions:

1. Where is a potential trigger or entry point for a trend trade?
2. When is the trend over or reversing?

Getting Started

A couple basic principles: If a stock price is above a simple moving average (SMA), the trend is considered up; if the stock price is below the moving average, you’re probably looking at a downtrend.

Also, there are different time periods associated with a moving average— it could be a 10-day, 50-day, or 200-day moving average. What’s the difference? The shorter the moving average, the shorter the trend it identifies, and vice versa (see figure 1).


SHORTER-TERM MOVING AVERAGES

FIGURE 1: SHORTER-TERM MOVING AVERAGES, such as the 10-day (blue line), tend to closely track a stock’s daily and weekly ups and downs. By contrast, the 50-day (orange) and 200-day (purple) offer a smoother, more gradual look at the longer-term trend. Source: TD Ameritrade. For illustrative purposes only.

What’s Your Time Frame?

Traders simply need to match the appropriate moving average time period to their trading time frame, whether that’s short, medium, or long term.

  • For example, a short-term trader may monitor the 10-day moving average. If a stock price is above the 10-day SMA, then the short-term trend is up (the opposite is true for a downtrend).

  • Next, if the stock is above the 50-day moving average, then the intermediate- term trend is generally considered to be up.

  • Finally, the “big dog” of moving averages is the 200-day. If a stock is trading above that level, the long-term trend is considered up; generally, the 200-day is seen as a proxy for the long-term trend (and it’s the one you might see on a television business report).

Once you’ve assessed your time frame, answer the questions.

1. Where Is The Trigger For Entry?

To create your own moving average crossover system, the first step is to choose your time frame. As an example, we’ll look at an intermediate-term approach, which could include 20-day and 50-day moving averages. When the shorter average (the 20-day in this case) crosses above the longer average, that’s often a “buy” signal.

2. When Is The Trend Over Or Reversing?

Sell signals happen when the shorter moving average crosses below its longer counterpart.

Why use two moving averages? With just one, a buy signal is triggered whenever the closing price moves above the moving average. That signal may or may not be valid. The moving average crossover technique can help you avoid false signals and whipsaw moves.

Let’s look at how a simple moving average crossover system can generate trigger points for entries and exits (see figure 2).

A MOVING AVERAGE CROSSOVER

FIGURE 2: A MOVING AVERAGE CROSSOVER scan produce “buy” or “sell” signals. Use TD Ameritrade moving average functions to catch a trend. Source: TD Ameritrade. For illustrative purposes only.

Look For Confirmation

You may remember that confirmation is a basic tenet of technical analysis. Generally, no indicator or chart pattern stands alone. The moving average crossover technique should be used in combination with other confirmation indicators, such as support or resistance breakout points and volume readings (see figure 3).

A moving average crossover

FIGURE 3: A MOVING AVERAGE CROSSOVER on the left side of the chart above confirms a resistance breakout from a double bottom and signals a trend opportunity. Source: TD Ameritrade. For illustrative purposes only.

In another example, moving averages can confirm a “double bottom” chart pattern (see figure 4).


A moving average crossover

FIGURE 4: A MOVING AVERAGE CROSSOVER on the left side of the chart above confirms a resistance breakout from a double bottom and signals a trend opportunity. Source: TD Ameritrade. For illustrative purposes only.

Ride The Waves

Moving average crossovers are helpful in identifying when a trend is beginning and when it may be ending. The crossover system offers specific triggers for entry and exit points. These triggers should be confirmed with a chart pattern or resistance breakout along with supportive volume.

Just like those surfers in the ocean, it can be fun to catch a wave and ride it for a while. Just be sure to pay attention to the exit points so you know when it’s time to jump off for safety.

Cowabunga!

These Essentials will help you learn to identify potential buy and sell signals using technical and intermarket analysis.