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.
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
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
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
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
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