It is much easier to swim with the current than against it. The same is generally true in trading. Most technical analysts believe that traders generally have a greater probability of success in buying a stock when it, and ideally the market as a whole, is currently trending higher, than they do in trying to identify and enter at the exact bottom of a downtrend. Moving averages can be helpful in indicating whether a stock is currently trending higher or lower, but traders must be careful to recognize what moving averages can and cannot do.
Comparing the current price to a moving average can help traders objectively identify a security's current trend as bullish, bearish, or neutral. This simple piece of information can go a long way in helping traders successfully take advantage of meaningful price movement.
While technical analysis considers a current trend direction to generally be likely to continue, trends do generally change direction at some point, and can change unexpectedly and dramatically. As such, while moving averages may help them identify the current trend direction, traders must be careful not to blindly assume that it will continue indefinitely into the future.
How moving averages work
Moving averages can be calculated in several ways. One commonly used method is a Simple Moving Average (SMA), which calculates and plots the average closing price for a given security over a rolling timeframe. Short-term traders tend to focus on shorter, or "faster," moving averages of 10- or 20-day periods, while intermediate- and longer-term traders tend to focus more on "slower," often 50- or 200-day, moving averages.
The basic interpretation of a moving average is simple: if the current price of the security is above a given moving average, especially if the moving average line itself is rising, the security is considered to be in an upward, or "bullish," trend. Conversely, a security whose price is below a given moving average, especially if the moving average itself is falling, can be deemed downward or "bearish."
Moving averages generally do an excellent job of identifying the trend, as it currently stands. However, many traders fall into the trap of assuming that the currently indicated trend direction will continue into the future.
Moving average pitfalls to avoid
There are two primary mistakes that traders often make when using moving averages:
- The first mistake is assuming that the current trend is destined to last indefinitely into the future. While it's important to have some confidence about a trade when entering it, many traders become so convinced of the future direction that they fail to implement risk management or monitoring strategies. Failure to monitor stocks or incorporate risk management strategies can result in potentially devastating losses, especially when the downturn is unexpected. Keep in mind that there is no guarantee that the execution of a stop order will be at or near the stop price so having a stop order in place can still result in a loss. No matter how strong the trend appears to be, it is important to remember that circumstances can change at any time, whether security-specific or from changing broader market conditions, and contingency plans are essential to overall trading success.
- A second mistake is relying solely on moving averages when making trading decisions. A perusal of any bar chart drawn with one or more moving averages overlaid demonstrates that some crossovers will prove beneficial while others will not. Because there is no single technical indicator that works on every chart, every time, experienced traders rely more on a "weight of evidence" approach to analysis. In this approach, a price crossing above a moving average line would be just one of several indicators or tools reviewed. If other tools or indicators also point toward bullish signals, the bullish weight of evidence is considered significant. On the other hand, conflicting signals from various indicators may cause a trader to consider other opportunities, or hold off for further analysis.
Moving averages: One piece of the broader puzzle
So if moving average signals are sometimes right and other times wrong, then why would traders use them at all? Because one of the oldest proverbs in trading states that "the trend is your friend," And moving averages provide one of the simplest methods for identifying the current trend.
Moving averages can help to answer the question: "What is the current trend?" This is, however, only one of several questions traders should ask themselves when making trade decisions, such as:
- Do other factors support this conclusion, or do they challenge it?
- Should I get in, and if so, when?
- At what point will I get out, if I'm wrong?
Traders can get added insight into pricing action, when incorporating moving averages for a timeframe suited to their intended holding period. When used together with other indicators or triggers, they can also help traders determine when to enter a trade within the direction of that trend, a strategy employed by many successful traders.
The bottom line
In sum, traders can use moving averages to identify the current trend direction. However, the moving average timeframe should be relevant to the trader's intended holding time. Further, to avoid misinterpretation or overdependence on moving averages, traders should also consult additional indicators to gather a weight of evidence for the conclusion, and take proactive risk management steps, such as stop orders, to avoid potentially severe losses, should conditions change.