Everyone who trades based on technical analysis gets faked out by some indicator some time. It certainly has happened to me.
It happens quite often with moving averages, where you might see a signal to buy or sell only to have the stock move against you.
That doesn’t make moving averages any less valuable as a tool, but rather makes it important that you refine your techniques, know what to look for and how to spot a fakeout.
Moving averages and fakeouts explained
Moving averages are widely used to help smooth out improve the read on price action, by filtering out the noise. This is done by taking a specific price point — open, close, high, low — for a specified period (hourly, daily, weekly).
It’s a lagging indicator, because it’s based on historical prices.
There are two main types of moving averages: simple and exponential.
Simple moving averages take the sum of prices over the specified time frame, divided by the number of periods in the window, while exponential moving averages use a more-advanced or “sophisticated” calculation that places more weight on recent price action.
Moving-average crossovers are a building block of technical analysis and can be very powerful, but that’s why fakeouts also can be dangerous. When the shorter-term moving average crosses above the longer-term moving average, this is generally a bullish signal. The opposite is true when the short-term moving average crosses below.
Let’s examine a fakeout.
Here’s an annotated daily chart on NVIDIA Corp. (NVDA). Follow the 20-day simple moving average line and you will see where it crossed below the 50-day simple moving average, indicating potentially bearish price action.
The next move on the stock wasn’t bearish; instead, it was quite the opposite, as NVDA actually rebounded and traded higher.
To reduce the chance of being faked out, pair moving-average crossovers with other technical indicators, such as support and resistance lines. If you look back, NVDA formed a triple top, which may have been the reason for the pullback. Looking at the uptrend line on the chart, it clearly held as support, and the stock bounced right off and traded higher.
Thus, the support line might have told you that this was one crossover that wasn’t sending a clear signal, giving it high potential to be a fakeout.
The bottom line
Pair moving-average crossovers with other technical indicators, such as trendlines and support and resistance to decrease the chances of being faked out by an indicator. Sometimes a crossover is a true signal, sometimes it’s an offshoot of a stock that is testing support and resistance areas; knowing the difference will help you spot real moves that are worth trading.
Petra Hess runs PetraPicks.com. She is a technical swing trader and long-term investor in domestic and Canadian stocks and ETFs.