Moving Averages - Is Your Stock Golden or Deadly?
When you invest in a stock, you are doing it for one reason - to make money.
That’s why it is so crucial to properly analyze and investigate a company before you decide to buy shares. Due diligence is the key to smart investing.
Whether you are analyzing a stock yourself or following an expert’s advice, one of two styles of analysis will likely come into play: fundamental or technical.
So which is best to follow?
The smartest investors use a combination of both techniques to profitably trade stocks.
Fundamental analysis involves reading and interpreting businesses’ financial statements. It is considered the cornerstone of stock analysis. If you are interested in learning more about it, we provide a free mini-course here.
The scope of this article, however, is on technical analysis… and how it can make you a better investor.
Technical analysis focuses on the study of price and volume activity. Utilizing this data can help you draw insights on market trends. And by using key technical indicators plotted on stock charts, you can find the ideal time to execute trades.
Think of it this way...
It’s one thing to know what stock you want to buy after investigating a company’s financials. But it’s another thing entirely to know the right time - or the right price - to buy it.
After all, you don’t want to buy a stock when prices are inflated. And you don’t want to sell it when it’s depressed. Technical analysis can help you determine if something is over or underpriced. It can also tell you if now’s the best time to get in or out of a trade.
Is Your Stock Golden or Deadly?
One of the simplest - yet most effective - forms of technical analysis is the study of a stock price’s moving average. This is its average closing price over a certain period of time.
Moving averages - or Mas, for short - can be used to smooth out the volatility you see in a stock chart. The shorter an MA’s duration, the closer it follows the stock price’s movement. The longer the duration, the less volatile the MA will be.
Many analysts use two key MAs of different durations to confirm bullish or bearish momentum. The combination we’ll cover is the 50- and 200-day examples. (Editor’s Note: It’s worth mentioning that Matthew Carr is a fan of the 100-day MA. In fact, he likes it so much that he called it “the most overlooked ‘buy’ signal in the market.” You can read about it here.)
Think of MAs like a baseball player's batting average. If a batter averaged .300 over the last 200 days and .220 over the last 50, he or she is clearly in a slump.
Likewise, if the average stock price over the last 50 days is below that of the last 200, the stock is in a downtrend.
The idea is to track and identify when these lines cross one another on the chart. When the 50-day MA crosses below the 200-day, this is a bearish signal known as a “death cross,” which means the stock has entered a downtrend.
When the 50-day MA crosses above the 200-day, it is a bullish signal known as a “golden cross.”
Take a look at the two-year price chart below for Intel Corp. (Nasdaq: INTC).
As you can see, if you had bought shares of Intel when the stock hit a golden cross (green circle) on February 19, 2013 - which suggested a bullish price trend - and sold when it hit a death cross (red circle) on March 23, 2015, you could have banked a 34.9% gain over a two-year period.
Also, notice that our indicator correctly signaled a downtrend that continued for months after the death cross, which you would have largely avoided by exiting at that point.
The best part? It takes only a few minutes to set up and digest these charts. You can use free sites like stockcharts.com and tradingview.com to map out moving averages. There may also be tools on your broker’s website.
Just be careful. Because, as I’m about to show you, this indicator isn’t foolproof...
What to Do When MAs Don’t Work
Our next chart looks at Cerus Corp. (Nasdaq: CERS).
As you can see, using the same strategy I previously described would have produced hectic results with this stock.
If you entered after spotting the golden cross, it would have resulted in a temporary gain... followed by a sudden drop. Likewise, exiting after the death cross would have caused you to miss the next big run-up.
Suffice it to say, technical indicators are not perfect in all situations.
For that reason, you never want to rely on one indicator on its own. You want to use them with caution - and always compare them to other technical indicators and fundamental metrics.
I should also mention that the 50- and 100-day moving averages I’ve mentioned so far are commonly called simple moving averages, or SMAs. This means that each day’s closing price is weighted equally when calculating the average.
Get Into Your Position Earlier With EMAs
We can also use what are called exponential moving averages, or EMAs.
An exponential MA is similar to a simple MA, except that the most recent stock price is weighted more heavily. This allows the EMA to follow the stock price a little more closely.
Let’s look at a comparison of the 50-day simple and exponential moving averages for Apple (Nasdaq: AAPL).
AsI said, both moving averages are very similar. Yet, as you can see, the exponential average moves slightly faster than the simple average. The EMA can make a difference in whether you enter or exit a position slightly earlier - and see a better gain.
You can use either simple or exponential moving averages in searching for a golden or death cross. But make sure you’re using the same type of average for both 50- and 200-day MAs.
And know that over longer periods of time, the difference between the simple and exponential averages becomes less and less meaningful. Using the EMA over the SMA is advantageous only for short-period MAs, such as the 20- or 50-day.
Using moving averages to determine if a stock is in an up or downtrend is a helpful tool when deciding whether to buy or sell. Adding this technical indicator to your toolbox will help make you a better investor.
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