Moving averages in a nutshell:
“Successful traders always follow the line of least resistance. Follow the trend. The trend is your friend.” – Jesse Livermore
This is a great quote from the legendary trader, Jesse Livermore, whose life was chronicled in the book Reminiscences of a Stock Operator by Edwin Lefevre.
But how exactly is an investor to know which is the path of least resistance? How do you know if there is even a trend to follow? One of the most helpful tools that we can use when analysing trends (or lack thereof) in the market is moving averages. A moving average is a widely used indicator in technical analysis that helps smooth out price action by filtering out the “noise” of random short-term price fluctuations. It is a trend-following, or lagging, indicator because it is based on past prices. This is an important point, we don’t know that a trend exists until it is already in place.
There are different types of calculations which can be used to create moving averages but the two most popular are simple and exponential. The simple moving average (SMA) calculates the arithmetic mean of price over a certain look back period. The exponential moving average starts with a simple moving average (SMA) and then calculates a multiplier for weighting the EMA. Without getting into the specifics of the math, what we need to know is that an EMA gives more weight to recent prices while the SMA assigns equal weight to all prices.
Moving averages can be used over different time frames to fit the particular trading or investment style of the person who is using it. Are you a short-term trader? The 10 or 20-day moving average may be right for you? What about long-term investors? Perhaps the popular 200-day moving average fits your style. The shorter the time frame of the moving average, the more sensitive it will be to price changes in the market and vice versa; the longer the time frame used to calculate the moving average, the less sensitive it will be to changing prices.
What do the moving averages tell us? Well at a high level, if the moving average is rising, the market is said to be in an uptrend for that time frame. If the moving average is falling, the market is said to be in a downtrend over that period of time. Many investors stop there but it is important to remember that there are actually three trends that can exist in a market: up, down…and sideways. The direction of moving averages can be instrumental in helping us to determine the trend.
To illustrate the importance of knowing the direction of the trend, I ran a study on the S&P 500. When the 200-day moving average is rising, the index is higher six months later 72% of the time. But when the 200-day moving average is declining, the index is higher six months later 62% of the time (based on data back to 1950).
At Chaikin Analytics, we use two moving averages on our charts:
- The Chaikin Trend which is a 200-day double exponential moving average is displayed in orange and is designed to identify the intermediate-term trend of the stock or ETF
- The 21-Day Exponential Moving Average which is the middle line of the three white dashed lines on the display and is designed to indicate the short-term trend.
Looking at the SPDR S&P 500 ETF (SPY) we can see good examples of the different trend environments for both time-frames over the past year.
The green bars indicate the daily price of SPY and we can see that from July until October, price was above both of the moving averages which were both moving higher, the market was in an uptrend.
In October, the price fell below the 21-day EMA and a few days later, the moving average turned down to indicate that the short-term trend was now lower. Also in October, the price went below the Chaikin Trend and remained there long enough to cause this intermediate term measure of trend to also move lower. By October 19th, both of the moving averages were sending a clear signal, the trend of the market is down.
After the bottom was in place in December and prices began to move higher, SPY went above the 21-day EMA and it quickly began to rise. In February, price rose through the Chaikin Trend and this moving average turned higher as well. Again, the message was clear…the trend is up.
And what about now? Price is above both moving averages which are moving higher.
This is by no means meant to be an exhaustive study of moving averages but is meant to be a useful starting point for understanding what a moving average tells us about the prevailing trend for a specific time frame.
Everyday in my Morning Insights note to Chaikin Analytics members, I highlight a bullish or bearish stock idea. Using the moving averages is a big part of my process for finding these ideas. I actually screen for them using our Screening Tool. This is a great starting point to narrow down a broad universe of stocks into a list that is easier to analyse. Here I have taken the S&P 500 down to a list of 49 stocks which are trading above their 21-Day EMAs and their rising Chaikin Trend lines; they are in uptrends. I have also required that the stocks have a bullish Chaikin Power Gauge Rating, strong money flow and strong relative strength, which we will address in a separate post.
From here we can begin the process of identifying stocks that are potentially good trading or investment candidates or as Jesse Livermore put it, stocks where the trend is our friend.