How to predict the market’s next moves

MIAMI, Fla. (MarketWatch) — If you ask many traders which market indicator they’d use if they could only choose one, it would be moving averages.

Even if you don’t believe in technical analysis, take a look at moving averages, a powerful but simple indicator that gives important clues to market direction. The most popular are the 50-day, 100-day, and 200-day moving averages, although people use the 200-day measure as a guide to the long-term market trend.

But in a recent article, MarketWatch columnist Mark Hulbert found that a portfolio following the 200-day moving average hadn't produced such impressive results over the past 20 years. “Even on a risk-adjusted basis over the last two decades, the 200-day moving average has lagged a simple buy-and-hold approach"

If you’re a buy-and-hold investor, you’re probably not interested in timing strategies, and as Hulbert concludes, the 200-day moving average may not be the ideal vehicle for timing the market. If you’re a trader, however, you can use moving averages for timing. More important, moving averages can help provide clues to market direction.

Short-term traders tend not to use the 200-day MA for timing, but prefer the 13-day, 20 or 21-day, or 50-day. For example, long-term trader Laszlo Birinyi, president of Birinyi Associates, makes his trades based in part on a stock’s 50-day moving average.

Other traders use even shorter time frames such as the 8-day or 10-day moving average. They use it both for support and resistance, and also observe when one moving average crosses another. One popular crossover strategy: when the 8-day MA (the shorter moving average) crosses above the 13-day MA (the longer moving average), this is a signal to buy. Conversely, if the 8-day crosses below the 13-day MA, this could be a signal to sell.

Using moving averages for support and resistance

Traders, and investors, also use moving averages for support and resistance. For example, in June the S&P 500 sliced through the 50-day and 100-day moving averages. If the benchmark were to drop below its 200-day moving average, this would be a major sell signal.

Why? Because the 200-day moving average, and other moving averages, act as support (which is like a floor), or resistance (which is like a ceiling). It takes a lot of buying or selling pressure to move the market above or below a moving average.

Yet moving averages are not perfect. First, they are considered lagging indicators, which means they follow prices. In other words, they are often slow to react to market conditions. By the time the index drops below the moving average, you may already be out of luck. In addition, moving averages are not ideal during choppy trading environments. Like any indicator, you never want to make trades based solely on its results without confirming with other indicators.

Moving averages for rookie traders

If you are a rookie trader and want to know more about moving averages, here’s a brief tutorial.

Moving averages show the value of a security’s price over a period of time, such as the last 10, 20, 50, 100, or 200 days. Most people overlay the stock price over its moving average on a chart to get a good feel where the stock or market is headed.

Calculating a moving average is not difficult. For example, the 20-day simple moving average is found by taking an average of the last 20 days of the market’s closing price and dividing by 20. So as the 21st day is added, the first day is dropped off. It’s constantly moving, which is why it’s called a moving average. In addition to the simple moving average, many people use the exponential moving average, which gives more weight to the most recent time periods.

Many traders have designed strategies based on moving averages. With the help of a professional technician, last year I back-tested dozens of trading strategies. What did I find? The moving average crossover strategy (buy when the 50-day crosses over the 200-day, and sell when the 50-day crosses below the 200-day) consistently ranks high, especially when the market is trending.

The advantage of using moving averages is that it helps keep your emotions out of the trade.

Bottom line: If you are an investor or trader, you can gain valuable information by watching how stocks or indexes react when they rise above, or below, their moving averages.

Credit: Michael Sincere is the author of Start Day Trading Now (Adams Media, 2011), All About Market Indicators (McGraw-Hill, 2010), and Understanding Stocks (McGraw-Hill, 2003).