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Following the mighty 500-day average

Posted
5/7/2012 10:14:00 AM
By: optionMONSTER
Referenced Stocks:AMZN;LPS;NWY;TEX;ZION

I am a believer in long-term trends. Today we'll consider an indicator that often proves very useful for detecting such patterns: the 500-day moving average.

Like the wind, stocks move in a specific direction. The reason for this movement is not always clear. Maybe there's higher air pressure over the sea than over the plains. Maybe more investors want to own a stock than want to sell it.

When engineers want to track the movement of air, like in a wind tunnel, they use plumes of smoke. And when traders want to identify trends, we use moving averages.

Most people are familiar with averages such as the 50-day or 200-day, which can also be powerful indicators. The 500-day tracks much longer-term trends and is especially useful in today's market because the crashes of 2008 and 2011 continue to reverberate on many charts.

Stocks can appear ready for a decent move, but then stall or reverse. This kind of price action often make no sense until you add the 500-day to your chart.

Consider Terex , which looked bullish in April 2010 as its 50- and 200-day moving averages were both climbing, but then the 500-day came crashing down like an eagle on a prairie dog. TEX also surged higher this year on strong earnings growth. It hit the 500-day in mid-February and has been trading on either side of it since. Another recent example was Whirlpool , which rallied violently in January and February before tanking at the 500-day (orange line on chart below).

whr

It also works on the long side, as we see with Amazon.com . The e-commerce giant has been trending higher since late 2008, but started breaking down in November. Some folks thought it was ready to collapse after the shares slipped below their 200-day, but the 500-day emerged as support. At this point, AMZN could go either way. The key point is that the 500-day is an important level to watch. Stocks seldom go straight through it without at least a pause.

Now, don't think that moving averages are some kind of black magic or like cosmic rays shooting down from the heavens. They should always be understood for what they are: tangible representations of processes that are inherently intangible, like the spread of specific products or the deterioration of an industry. Moving averages simply reveal these bigger economic and societal processes over different time periods.

Finally, let's consider a few more stocks where the 500-day is now potentially important.

(A version of this article appeared in optionMONSTER's What's the Trade? newsletter of April 25. Chart courtesy of tradeMONSTER .)