How to Use Moving Averages Part -II

In Continuation of Previous Post

Interpretation

The most popular method of interpreting a moving average is to compare the relationship between a moving average of the security’s price with the security’s price itself. A buy signal is generated when the security’s price rises above its moving average and a sell signal is generated when the security’s price falls below its moving average. Moving can be used for

1. finding Support and Resistance
2. Trend Identification.

Let discuss both of them with example.

Finding Support and Resistance

The following chart shows the S&P 500 from May 2012 through Jun 2013-07-01

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Also displayed is a 50 Day simple moving average. “Support” arrows in Green Colour were drawn when the S&P 500 took support at 50 DMA during uptrend.

“Resistance” arrows Red Colour were drawn when it resistance at 50 DMA during its downtrend.  below its moving average.

Trend Identification

The most popular moving average is the  200-day moving average. This moving average has an excellent track record in timing the major (long-term) market cycles.

Golden Rule: Bulls Live above 20 DMA and Bears are active below 200 DMA.

200 DMA is used by Fund managers to add and exit a particular stock from the portfolio. As seen in below example, Microsoft broke its 200 DMA on 29-Sep-2012 at $30 and after that stock entered in a downward move corrected till  $26 consolidated and started its base forming.

On 09-Apr-2013 8 month after that Microsoft was able to close above its 200 DMA@$ 29.6 and started a big bang rally and went on till $36 by 5^th June 2013. Close above 200 DMA has sparked 20% rally in just 2 months.

Traders can apply the moving averages on Weekly and Monthly time frame also. As a thumb Rule Higher the time frame stronger is the signal. As depicted in below example of Gold on Weekly time frame.

Gold has crossed its 200 Weekly Moving Average in early 2009 @ $ 725and from that time till next 4 years its has been in Bull market. Gold made a High of 1920 during the period.

Gold broke in 200 WSMA in May-2013 and has been falling since than. Both the rise and fall of Gold is shown in the below chart.

Moving Average Crossovers(MACO)

Two moving averages can be used together to generate crossover signals, crossovers involve one relatively short moving average and one relatively long moving average. As with all moving averages, the general length of the moving average defines the timeframe for the system. A system using a 5-day EMA and 20-day EMA would be deemed short-term. A system using a 50-day SMA and 200-day SMA would be long-term.

A bullish crossover occurs when the shorter moving average crosses above the longer moving average. This is also known as a golden cross. A bearish crossover occurs when the shorter moving average crosses below the longer moving average. This is known as a dead cross.As Seen in below example of Caterpillar when 5 EMA (red) crossed 20 EMA (blue) on downside its formation of bearish crossover and Caterpillar entered in downtrend correction from $95 to $83.

We can also see the bullish crossover when EMA (red) crossed 20 EMA (blue) on upside and stock rallied.

Moving average crossovers produce relatively late signals. After all, the system employs two lagging indicators. The longer the moving average periods, the greater the lag in the signals. These signals work great when a good trend takes hold. However, a moving average crossover system will produce lots of whipsaws in the absence of a strong trend.

Conclusion

Readers do note moving average trading system is not intended to get you in at the exact bottom nor out at the exact top. Rather, it is designed to keep you in line with the security’s price trend by buying shortly after the security’s price bottoms and selling shortly after it tops.