Commentary: A moving average may be the single most popular indicator used on stock charts. One of the reasons traders rely on moving averages is because they do a great job of smoothing out the daily fluctuations in price and presenting a visual representation of a stock’s trend. Basically, a moving average is the average price of a stock over a specified number of trading days. While there are many values and combinations that traders can use, some of the most common values used are the 20-, 50-, and 200-day moving averages. These three averages offer a basic way to assess a stock’s short, intermediate and longer term trend. Traders should pay particular attention to a moving average’s slope and its position relative to other moving averages. When a faster moving average is above a slower moving average, it reveals that a stocks trend has been higher in the near term than over the longer term average. While it may seem that a simple technique like this would offer limited value, often simply trading in the direction of the moving averages will significantly improve a trader’s odds. (For a quick refresher, check out the Moving Averages Tutorial.)
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One set of values a trader can use is to watch for stocks where the 20-day moving average is below the 50-day moving average. When this situation occurs it signals a stock whose average price over the past month (20 trading days) is below the average price over the past two and a half months. This means that on average, any trader who established a position over the past two months will be underwater on the trade. Often, the initial cross of the 20-day moving average below the 50-day moving average will provide a warning signal that a stock is rolling over into a correction or downtrend. While the majority of the market indexes remain in healthy uptrends, some of the individual sectors are showing some weakness, with the 20-day moving averages crossing down below the 50-day moving average.
The Financial Select Sector SPDR (NYSE:XLF) ETF is an example of a sector ETF that has started to show some weakness and has its 20-day moving average crossing below the 50. XLF broke under its 50-day moving average about a month ago, and has been consolidating underneath the average, with very little progress. Often, a stock will resume the breakdown when the moving averages catch up to the trading price. One thing to keep in mind is that the crossover is not a magic signal to short a stock; in fact, the last crossover in XLF back in July signaled a decent buying opportunity. However, it does show objectively that a stock is experiencing weakness, and as such should be monitored.
Semiconductors HOLDRs (NYSE:SMH) is another ETF that recently broke under its 50-day moving average and under a recent base. It is about to cross the 20- and 50-day moving averages as well, just as SMH bounces back into this resistance area. The semiconductors were leading the markets for much of the summer. They have now set a lower low, and are in danger of failing on this bounce higher. One key level to watch is to see if SMH can close back above its 50-day moving average and begin to consolidate above this level. This would eventually negate the negative crossover, and possibly set up a bear trap.
Utilities Select Sector SPDR (NYSE:XLU) is another ETF that has the 20-day moving average crossing below the 50. It is also in the process of bouncing back into this moving average cluster after testing a major support level near $28. The key level to watch here is how XLU deals with the moving averages as resistance, as a move back above the cluster could be a sign of strength. However, if XLU rolls over in this area, it could be a prelude to a much larger breakdown.
The iShares Dow Jones Transportation Average (NYSE:IYT) is another example of an ETF bouncing back into resistance formed by the 20-day moving average crossing below the 50-day moving average. IYT also set a lower low in the recent pullback in early November, which hints at weakness. IYT is currently at a critical juncture, and needs to hold up in this area in order to avoid a failure and possibly setting a lower high.
While a moving average crossover is not a magic signal to enter a trade, it does offer an objective view into the trend of a stock. It is worth paying attention to the direction, slope and order of the moving averages, as it not only measures the average price of a stock, but the behavior of traders. When a cluster of moving averages is headed lower, it often signals that traders are selling into rallies, and thus the moving averages can act as resistance. With several sector ETFs in this situation, it bears watching to see how they react at these critical levels. The result could not only offer a good trading opportunity, but also a clue into the next move for the markets. (For more, see Simple Moving Averages Make Trends Stand Out.)