Keeping Your Trends Close with Moving Average Crossovers

Whether you’re surfing the waves on Hawaii’s North Shore or the volatile markets on the trading screen, failing to catch the right wave at the right time can leave you vulnerable to a nasty wipeout. So, before you jump in, paddle out for a moment and let’s take a closer look at the swells.

Surfers and traders share at least a few common traits (if you fall into both categories, we salute you). For either pursuit, recognizing and riding that big wave is crucial to your strategy. You have to know when to get in and when to get out; when to go big, and when to go home.

Markets are dynamic, just like the ocean. Prices are constantly moving, forming small and large waves, which, in finance-speak, are called “trends.” Markets and trends are inseparable. Whether we’re talking about a blue-chip stock or a T-bone steak, prices don’t sit still. Over time, they change—sometimes moving faster than at other times.

For our purposes, a trend can be defined simply as the general direction of a market over the short, immediate, or 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 (SMA) 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 maxim, how can a SMA crossover system help? Start with three questions:

1. Which direction might the market be trending (if at all)?
2. Where might be a potential entry point for a trend trade?
3. When might a trend be ending or reversing?

Getting started

Consider these basic guiding principles:

• Uptrend: If a stock price is above a SMA and that SMA is moving higher, you might be looking at an uptrend.
• Downtrend: If the stock price is below the SMA and that SMA is moving lower, you might be looking at a downtrend.

Caveat: These principles are intended to help you interpret the potential direction of a trend, not to definitively call its direction. If a stock price is above the SMA, and if the SMA itself is moving upward, then there may be a stronger likelihood that you’ve identified an uptrend. The reverse may be true for a downtrend. But bear in mind, trends can change, and other indicators can also be used to interpret trend direction. They may even conflict with one another from time to time.

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

What’s your time horizon?

Match the appropriate SMA time period to your trading time horizon, whether that’s short, medium, or long term. For example:

• Short-term trend: A short-term trader may use the 10-day SMA to monitor the short-term trend. If a stock price is above the 10-day SMA, and the SMA is moving higher, then the short-term trend may be up (the opposite is true for a downtrend).
• Intermediate-term trend: If the stock is above the 50-day SMA, and the SMA is moving higher, then the intermediate-term trend is generally considered to be up.
• Long-term trend: Finally, the “big dog” of moving averages is the 200-day SMA. If a stock is trading above that level, and the SMA is moving higher, the long-term trend is considered up; generally, the 200-day SMA is seen as a proxy for the long-term trend (and it’s the one you might see on a TV business report).

Using two moving averages to better identify trends

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

1. Where is the trigger for entry?

To create your own SMA crossover system, the first step is to choose your time horizon. 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 MA in this case) crosses above the longer average, that often signals a stronger likelihood of an uptrend. Some traders will take this as a potential buy signal.

2. When is the trend over or reversing?

When the shorter MA crosses below its longer counterpart, that may signal that an uptrend may be ending or perhaps even reversing to the downside. Some traders might take this as a signal to sell their positions.

Why use two moving averages? With just one, a potential buy signal might be triggered whenever a stock’s closing price moves above the MA. This signal may or may not be valid. When markets get choppy, price can close above and below an MA in frequent succession. This can leave you vulnerable to getting whipsawed. The MA crossover technique can help you avoid false signals and whipsaw moves.

To see how a SMA crossover system can generate trigger points for potential entries and exits, see figure 2.

Look for confirmation

Confirmation is a basic tenet of technical analysis. Generally, no indicator or chart pattern stands alone. So when you use the SMA crossover technique to find potential entry or exit signals, you may want to use it in combination with other indicators like support or resistance breakout points, volume readings, or any other indicator that may match a given market scenario (see figure 3).

Ride the waves

Simple moving average crossovers are helpful in identifying when a trend might be emerging or when it might be ending. The SMA crossover system offers specific triggers for potential 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 exhilarating to catch a wave and ride it to the end. Just be sure to pay attention to the exit points so you know when it might be time to jump off.