Using Moving Averages to Find Trade Entries (and Exits)
Moving averages are a flexible technical tool for traders.
Moving averages are a great tool to use to help determine relative strength in a stock’s price. A rising (upward sloping) moving average indicates that price has been rising over x number of days.
When shorter term MA’s cross over longer term MA’s, it indicates that there is relative strength in more recent price action and usually precedes a trend change to the upside. These can be a great opportunity to enter a stock at the beginning of a new uptrend.
In order to improve entry points, another technique to use in conjunction with the MA crossover is to look for a “swing low” entry. A swing low is a set of three candlesticks, where the price has been pulling back, the second candle has a lower low than the first candle, and the third candle has a higher low than the second. This signals that the selling is at the very least taking a break and price could be reversing back to the upside.
The crossover and swing low entry technique can also be used in reverse for shorting stocks. When the shorter term MA crosses below the longer term MA and the MA’s begin to slope downward, a swing high will signal a short entry.
Not all crossovers are created equal.
MA’s are a great tool to add to a trading strategy, but they are just that – a tool. Nothing trumps price action. Entries and exits should not just be made blindly. It is important to watch price levels, pivot points, and support or resistance levels.
If the crossover occurs just as the stock has had a good leg up, it’s best to wait for a pullback.
Don’t enter a stock that is up against important resistance simply because the MA’s crossed over. Similarly, use price levels to determine stops, as there often will be overshoots below MA’s. So long as the MA’s remain upward-sloping a drop below an MA does not necessarily signal a trend change.
This strategy works best with lower beta stocks. The concept of MA’s is to smooth out average price action. Stocks that move more smoothly such as lower beta stocks will have a higher success rate using this technique. It does not work well with more volatile stocks, as these will cause too many whipsaws.
This technique does not work with ranging stocks. You can tell when a stock is ranging when the MA’s intertwine with no specific slope.
It helps to watch the more standard MA’s, such as the 50 and the 200 MA’s. Although the technique can still be used when a stock is below its 200 MA, it will work better when the price is above these MA’s.
I prefer using the 10, and 30 MA’s since it seems to work best with my particular trading style. I have seen many variations used, such as the 10/20, 20/40, 20/50; I’ve also seen EMA’s used, such as the 7/13 or 13/34 combinations. Some traders use three MA’s, such as the crossovers of 5/10/20 or 10/20/30. Whichever ones you use will depend on your personal trading style and preferences. Using shorter term MA’s will signal entries and exits more accurately, but will cause more whipsaws than using longer term MA’s.
As always, no trading strategy is foolproof.
Every trade involves risk, and proper risk management should always be employed.
Photo Credit: Getty Images/Ikon Images/Gary Waters