Technical traders often use moving averages as an indication of where a stock is trending or in range. But another way to use moving averages to signal potential trades is by watching for crossovers.
Here’s how they work:
Moving-average crossovers explained
Moving average crossovers are simple ways to find buy and sell signals.
The market generates a buy signal when the short-term moving average crosses above the longer-term moving average. On the other hand, a sell signal is generated when the short-term moving average crosses below the longer-term line.
The time periods used for the moving average — and they can vary from a matter of hours to hundreds of days — dictate the amount of signals that are generated. The shorter the time frame, the more signals you get; with longer time frames, the opposite is true.
Let’s take a look at some examples. Check out the daily chart on Lowe’s Companies (LOW):
In the annotated chart above, the 20-day simple moving average clearly crossed above the 50-day simple moving average. Consequently, this was an indication to get long the stock. That in mind, you might have set a profit target thereafter, looking to get out of the position if the 20-day simple moving average crosses below the 50-day simple moving average.
Here’s a look at how the trade would have turned out:
Now, let’s look at LOW using short-term simple moving averages.
Here, the 5-day and 15-day simple moving averages generated multiple signals; if you followed them to a T, you would’ve gotten chopped up.
The bottom line
Moving-average crossovers can be powerful tools for technical traders. They give you an idea of which direction a stock or ETF might move next. As with nearly all technical strategies and chart patterns, however, you’re getting a hint or an indication, not certainty about what will happen next. Keep that in mind when using them as a factor in your trading decisions.
Davis Martin is the lead publisher at DailyProfitMachine.com. He trades SPY calls and puts and swing trades mid-large cap stocks and stock options.