If you want to learn how to use technical analysis, you need to understand it’s an art form. 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. Rather, you should look to refine your technique, and learn what to look for and how to spot a fakeout.
How to Use Technical Analysis: Moving Average Crossover Fake Outs
Moving Averages Explained
Moving averages are widely used to help smooth out improve the read on price action. Basically, moving averages help to filter out the noise. This is done by taking a specific price point. Moving averages could be based on the open, close, high or low close prices for a specified period.
You need to keep in mind one thing: moving averages are lagging indicators, because it’s based on historical prices. This is one factor you need to understand when learning how to use technical analysis.
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
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 you’re learning how to use technical analysis, it’s always a good idea to wait for confirmation.
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.
You could get into call or put options on a stock depending on where the shorter-term moving average crossed. If the shorter-term moving average crosses above longer-term SMA, you could look to buy the stock or call options. The opposite is true when the shorter-term SMA crosses below the longer-term SMA. However, you need to keep in mind that there could be fake outs.
Moving Average Crossover Example
For example, here’s a look at Chipotle Mexican Grill (CMG).
Notice how the 13 simple moving average crossed above the 30 SMA on the hourly chart. Well, if you got long and didn’t take profits, you would’ve got faked out. When you’re learning how to trade technical analysis, you need to constantly study charts and patterns. I waited for CMG to fake out and actually show some confirmation before placing my trade. I actually bought call options in CMG and realized some nice gains.
Patience is key. You would want to see a clear break above and the stock staying above the 13 SMA, if you’re looking to get long. This is what we call the “money pattern.”
To reduce the chance of being faked out, pair moving-average crossovers with other technical indicators, such as support and resistance lines. Looking at the uptrend line on the chart, it clearly held as support, and the stock bounced right off and traded higher.
CMG was clearly trending higher and had some support around $425 on the hourly. If you waited for the 13-hourly SMA to cross above the 30-hourly SMA after CMG tested its support level, you would’ve got paid.
Now, the same could be done with 13-hourly SMA crossing below the 30-hourly SMA. However, you would look to short the stock or buy put options here. Moreover, you could use this tool to get into options on a stock as well.
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.
Jeff Bishop is lead trader at WeeklyMoneyMultiplier.com and widely recognized as the Mensa Trader. He runs short-term trading strategies, using stocks, options and leveraged ETFs.