Using moving averages to gauge market trends
How might you gauge the direction of an asset’s price trend? If you want to determine whether price is rising, falling, or moving sideways, you’ll find that it never moves in a straight line. Prices rise and fall, taking small steps or making big jumps.
Perhaps the best way to measure a market trend is to “smooth out” the price movements by averaging them and observing their gradual changes. This makes the moving average indicator an effective tool for gauging trends. It keeps you from getting distracted by the volatility inherent to price changes while showing you the market’s relative direction.
Key Points
- Moving averages can help investors gauge market trends by smoothing out price volatility.
- Short-term and long-term trends can be measured using different moving average time periods.
- The 50-day and 200-day moving average combination is a popular and effective tool for measuring trend strength and anticipating trend reversals.
What is a moving average and how is it constructed?
In technical analysis, a moving average is a calculation of successive prices of a given asset averaged over a period of time. We start by “averaging” prices over a number of days. That average will change, or “move,” after each consecutive day (hence, the term “moving average”).
Let’s construct a three-day moving average of volatile price movements over a period of six days:
Day 1: $10
Day 2: $9 (small decline)
Day 3: $14 (that was a big jump)
Day 4: $12 (another decline)
Day 5: $20 (another big jump)
Day 6: $15 (a big decline)
If you’re focused solely on daily price movements, it can be hard to tell whether this asset is moving up or down, simply because it’s jumping in both directions.
But if we smooth out the prices using a three-day period, we can get a clearer idea of the average direction.
| Daily closing price | Three-day moving average |
|---|---|
| Day one: $10 | |
| Day two: $9 | |
| Day three: $14 | $11 (average of 10, 9, and 14) |
| Day four: $12 | $12 |
| Day five: $20 | $15 |
| Day six: $15 | $16 |
While the daily closing prices seem to be jumping in all directions, the three-day moving average shows a steady uptrend from $11 to $16. Again, that’s what moving averages are designed to reveal—the underlying trend of price movements.
The big caveat here is that different moving average periods will give you a different trend reading. Some trends will move faster or slower, and there are cases where downtrends and uptrends may exist simultaneously depending on the time period you use.
Using moving averages to identify price trends
In the example above, we highlighted a three-day moving average for the sake of simplicity. In reality, three days might be too short a time period for most investors to find useful. Two principles apply here:
- Use shorter moving averages to gauge short-term trends and longer moving averages to gauge longer-term trends.
- The shorter-term the moving average, the closer it is to the underlying price movement, and the more volatile its trend will appear.
It’s important to understand these two ideas. Otherwise, things can get messy on a price chart. For example, let’s try plotting the 3-day, 5-day, 10-day, and 20-day moving averages against a longer-term 100-day moving average. (See figure 1.)
Instead of a clear trend, what you see in figure 1 is a rainbow of tangled price spaghetti. The different time periods show conflicting trends that may be confusing for most investors (although they could be helpful to traders who want to see where different trends are converging and diverging).
To keep things simple, let’s take a closer look at two of the most commonly used moving averages: the 50-day moving average and 200-day moving average.
The two most common moving averages for investors
Many investors follow the 50-day and the 200-day moving averages. The 50-day tends to give a good picture of the intermediate trend, while the 200-day helps investors see the longer-term trend.
In a bullish market, the 50-day moving average is commonly viewed as support. This means that if an asset pulls back from an uptrend, buyers may enter the market at the 50-day level, causing an asset’s price to bounce and resume its uptrend. In contrast, a close below the 50-day may be seen as bearish and may prompt buyers (or short sellers) to sell the asset.
Although the 200-day moving average can also be considered longer-term support, it may not give frequent signals, because prices (in a rising market) typically stay well above this longer-term average.
Combining the 50-day and 200-day moving averages
If you combine the 50-day and 200-day moving averages, the pair can make a strong technical indicator. Here’s how investors commonly use this combo:
- When the 50-day and 200-day are moving in the same direction, it indicates a strong trend (up or down).
- When they are moving in different directions (e.g., one is moving up or down and the other is flat), it indicates a weakening trend or a potential trend change.
- When the 50-day MA crosses under the 200-day, this is called a death cross and is considered bearish. It indicates the market may be heading toward a longer-term downtrend or bear market.
- When the 50-day crosses above the 200-day moving average, it’s called a golden cross and is considered bullish, particularly in a bear market. It indicates that the market may be heading toward a longer-term uptrend or bull market.
Good to know
Does technical analysis float your boat? Or are you more of a fundamentals person? Do you understand the difference? If not, start here.
Different types of moving averages
The moving average examples we’ve just discussed are the most basic type—hence the term simple moving average (MA or SMA for short). There are many other moving averages you can use. Two of the more common variations are the exponential moving average (EMA) and the weighted moving average (WMA).
These and other moving average variations are designed to be more (or less) responsive to recent prices. They may turn faster or slower depending on which type you use.
Traders who use moving averages to help guide market entries and exits may prefer more or less responsive moving averages depending on their trading approach. For example, if you tend to get in and out of the market quickly, you might prefer a moving average with fewer collection periods and/or a weighted average that skews toward the most recent data. On the other hand, if you’re more big-picture, long-term oriented, you might prefer to track trends with the 200-day moving average.
The bottom line
Using moving averages to gauge price trends is a blend of art and science. Moving averages can help you monitor the direction of a trend, but their effectiveness depends on which time period(s) you choose or combine. For example, you might see a definitive trend when looking at a medium-term moving average, but see the entirely opposite trend (or no definitive trend at all) when looking at a shorter- or longer-term average.
Curious? Try it yourself by trying different moving averages on a price chart, and you’ll get a better sense of how things look from different time-period vantage points. Eventually, you’ll discover which ones might be most compatible with your investing strategy.