How to Interpret and Use Moving Averages in Trading
Traders use moving averages to trigger buy and sell signals. In general, when a moving average slopes upward, you can infer that the trend is up, and when the moving average slopes downward, the trend is down.
One simple mechanical strategy that some traders employ works like this:
Buy when the moving average slopes upward and the closing price crosses above the moving average.
Close the position when the price closes below the moving average.
Sell short when the moving average slopes downward and the closing price crosses below the moving average.
Close the short position when the price closes above the moving average.
Although simple crossover strategies like this are remarkably effective in some trending situations, they’re equally ineffective in others. Many variables must be in alignment for this approach to work. For example, the stock must be trending, and the period for the moving average must be chosen carefully for the indicator to be effective. These trend-following systems fail miserably when a stock is range bound.
Consider this simple mechanical strategy on a chart of the Dow Diamonds (DIA), an exchange-traded fund that mirrors the Dow Jones Industrial Average. The chart is shown with a 30-day SMA.
The DIA showed a double bottom in June and July 2006. Using the trading rules of this simple mechanical strategy, the first buy signal occurred on July 24, 2006, when the stock closed above the SMA as the SMA turned higher. While the DIA traded below the SMA several times, it did not close below the SMA and generate a sell signal until February 27, 2007.
As it turns out, this sell signal was triggered during a retracement. Although not shown on this chart, the DIA ultimately traded quite a bit higher. Unfortunately, the simple mechanical system did not generate another buy signal until the trend was almost completely exhausted.
This problem points out the difficulty you face when your trading strategy is based on a moving-average or any trend-following system. When a stock is range bound or in a retracement, it’s difficult to know whether the buy and sell signals that the moving average crossover strategy generates are good entry or exit signals.
Keeping an eye on these complex retracement patterns helps you recognize that DIA may have entered a period of retracement — another way of saying the stock is trading within a range — in March and April 2007. You can’t know for sure whether DIA will break out of its consolidation to the upside or the downside until after the breakout actually occurs.
Waiting for the breakout causes you little, if any, harm. When DIA entered a retracement pattern in March 2007, the economic cycle appeared to be ascending and not ready to peak. Other traders, however, argue that you risk missed opportunities elsewhere when you’re waiting on position in a range-bound stock to break out.
It’s a good idea to wait for some sort of confirmation signal before entering or exiting any position in a stock or exchange-traded fund.