Moving Averages

Trend analysis is quite useful, but only part of our education as a technician. In a trending market, moving averages are even more important to assessing a stock than the trend is. And using multiple moving averages can considerably increase the accuracy of your analysis. A moving average is simply the average of the stock’s closing prices over a period of time. As a new closing price is made, it is added in to the calculation, and the oldest closing price is subtracted from the calculation.

The simple moving average (SMA) is just what it suggests: the total of all the closing prices for the time period divided by the period. An exponential moving average (EMA) instead weights more recent prices more heavily than older prices on the theory that they are more relevant. The EMA is more sensitive to recent movements but tends to give more false signals than the SMA.

Some use 20 and 50-day moving averages, but they are not any kind of standard. Many use the 14 and 30, or the 18 and 40, for example. The 20/50 SMA gives the best sensitivity on the time frame that is important to the call writer, but use what works best for you.

NOTE: The time periods actually are price bars based on the time frame of the chart, not days. For example, the 14-day moving average covers 14 days only on a daily chart. On a 60-min. chart it would reflect 14 hours, and on a weekly chart, 14 weeks. I refer to moving averages as having a period of X days because most analysis begins with a daily chart.

The use and interpretation of moving averages was discussed in the trade selection article. Note that moving averages work best for trending stocks. They are much less useful for ranging and volatile stocks, because the time lag for them to react to price movements is too great. The reason is that the moving average (like most indicators) is a lagging indicator and isn’t sensitive enough to give a signal reliable enough on ranging or volatile stocks for trade entry. The moving average convergence-divergence (MACD) indicator shares this failing with moving averages on trending stocks.

Pullbacks frequently can be predicted. Generally, prior to each pullback, the price advance will have taken the stock well above the 20-MA, creating a triangle-shaped area between the price line and the 50-MA. In a strong trend, the price line can soar quite high above the 50-MA without a pullback. The key to a pullback is when the price soars well above the 20-MA. If it creates a pronounced triangle above the 14-Ma a pullback is imminent in all but the most strongly advancing stocks.

Cirrus Logic (CRUS)

The CRUS chart at Figure 7.9 is a grand learning opportunity. It shows so much. In mid-April the price crossed above the 50-MA (Point 1). It pulled back briefly, then the 14-MA (red) crossed above the 50-MA at Point 2. This is a great combination for the covered call writer. In early May (Point 3) the stock pulled back below the 14-MA all the way to the 50-MA, recovered and again crossed above the 14-MA. This is a real show of strength.

Notice how CRUS pulled back numerous times to, or almost to, the 50-MA, at Points 3, 4, 5, 6 and 7. Each time price found support at the 50-MA and resumed the advance. As we saw in Chart 1 above, CRUS during this trend also held its trend line. Notice how prior to each pullback, the price advance took the stock well above the 14-MA, creating a triangle-shaped area between the price line and the 50-MA.

       Figure 7.9 – Chart showing ascension triangles, CRUS

These blue triangles are noted on the above chart as T1 through T5. When you look at a chart of a trending stock, look for these triangular spaces to form. The stronger the trend, the more pronounced the price moves and the larger the triangles can be. Notice how the real key to pullback is not the size of the triangle but the fact that a portion of the triangle is above the 14-MA.