Moving averages can help tell the tale

By
A A A

In an earlier column I described the stock market as a "great storyteller" and encouraged readers to come up with their own plot lines. For example, say you think that XYZ stock is going to rally because its widgets are gaining popularity. You then want to pick a trade that offers much more profit if you are right than loss if you are wrong.

Today I will examine moving averages because they are invaluable in this task. First, just because you have a hunch about a stock doesn't mean you're right. But moving averages can help confirm your belief. Second, moving averages can help you set entry and exit points. And third, moving averages can help you set stop losses so that you can stack the deck in your favor.

Moving averages are simply the average closing price over a certain number of sessions. So the 10-day is the average price in the last 10 sessions, and the 50-day is the average in the last 50 sessions.

The 5- and 10-day moving averages measure short-term, day-by-day moves. One recent example was Marathon Oil since mid-December because it had been rallying at a frenetic pace and staying above its 10-day moving average. Just when it looked as if it might have run out of steam, but the 10-day caught up and the stock surged higher once again.

EMC

Moving averages such as the 25-, 30-, and 50-day lines reflect intermediate trends lasting 2-3 months or longer. Stocks such as Netflix and DuPont, for instance, have repeatedly pulled back to these moving averages and bounced higher.

Long-term trends (six-plus months) can be spotted using the 100- and 200-day moving averages. Let's consider the data-storage name EMC to put the pieces all together. It made some quick moves in late 2009 when it stayed above its short-term moving averages, but then in October it fell below its 30-day moving average (green line on chart at right).

That meant the intermediate uptrend had ended, so it ground sideways for months until the 200-day caught up in May 2010 (purple line). It found support at that level, confirming that the long-term remained intact. Later in the year, it was back making new highs.

The 500-day moving average (dark blue line) can also show very long-term trends lasting years. I have recently been using this to avoid getting long stocks that are still dropping from the 2008 crash.

Take shipping companies such as DryShips and Diana Shipping as examples: They attempted to rally last year, only to slam into the 500-day day like a ripe tomato hurled against a brick wall. Not pretty. (Also look at Hartford Financial Services between April and August of 2010.) Even stocks in bullish trends, like Ford Motor and EMC, spent some time stuck at or near their 500-day averages before continuing higher.

These cases demonstrate how moving averages can help you spot trends and time entry points.

There's another interesting way to use them: Say a stock has been climbing for months. Its 30-day will be above its 50-day because its average price over the shorter amount of time should be greater than its average price over the longer period. Thus, a stock that is trending higher will have its 30-day above its 50-day and its 50-day above its 100-day and so forth.

Therefore, if the 100-day is below its 200-day, a stock may have trouble rallying. A good example of this is Citigroup, which spent more than a year grinding sideways. Sometimes--such as in January 2010--the 100-day was above the 200-day (good), but the 50-day was below the 200-day (bad). Other times, such as in June, the opposite was true. It was a mess, causing the stock to have many false starts.

But something changed in October and November, when the moving averages started lining up correctly, with the 30-day above the 50-day above the 100-day above the 200-day. Next thing you know, an explosive move higher. CBS and Disney followed similar patterns in September and October. So it can also be useful to look for moving averages to line up correctly before entering a position.

Using charts is like speaking a language: We all follow the same basic grammar, but we each have our own nuances. You need to find chart patterns that work for you and that you can understand. 

The key thing is to identify setups that provide a decent probability of success with a limited amount of risk. If you maintain discipline and stick to your guns, moving averages are a powerful tool to spot those opportunities.

(A version of this article appeared in optionMONSTER's Open Order newsletter of Jan. 26. Chart courtesy of tradeMONSTER.)



The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.

Copyright © 2010 OptionMonster® Holdings, Inc. All Rights Reserved.


This article appears in: Investing , Options

Referenced Stocks: EMC , MO

optionMONSTER

optionMONSTER

More from optionMONSTER:

Related Videos

Budgeting for Baby
Budgeting for Baby                  
A Home to Retire In
A Home to Retire In                 

Stocks

Referenced

69%
92%

Most Active by Volume

36,861,859
  • $16.97 ▼ 0.47%
32,617,111
  • $13.43 ▼ 5.36%
27,941,619
  • $14.59 ▼ 1.35%
27,374,198
  • $76.66 ▼ 3.01%
26,322,218
  • $97.70 ▼ 1.10%
22,609,259
  • $25.15 ▼ 0.08%
20,937,122
  • $99.77 ▼ 0.97%
20,391,245
  • $3.465 ▼ 0.72%
As of 10/1/2014, 12:05 PM

Find a Credit Card

Select a credit card product by:
Select an offer:
Search
Data Provided by BankRate.com