Using Simple Moving Averages

Simple Moving Averages (SMAs) can be a useful tool for a trader; a SMA is a fairly basic technical analysis tool in that it is useful for identifying trends as discussed in this tutorial by simply taking the previous prices for the previous X days and calculating the average. These averages are then plotted onto a chart and joined up to form a SMA line.

Since a SMA line contains averages, it allows a trader to filter out sharp price movements that may affect a company's share price from day to day. The most common moving averages used include the 10, 20, 50, 100 and 200 day simple moving averages (dSMAs). For the purpose of this tutorial, I will focus on the two most commonly used longer-term dSMAs - the 50dSMA (i.e uses the average price for the preceding 50 days) and the 200dSMA - and this tutorial will just look at two basic points relating to these longer-term SMAs.

Acting as Support and Resistance

When it comes to technical analysis, there is usually a reason why certain patterns of technical analysis methods hold, and these are usually related to psychological reasoning. In the case of support and resistance with longer-term SMAs, there is some simple logic that holds; a SMA is essentially a useful way of monitoring the trend of a company without having to revert to identifying trend lines or chart patterns.

The core SMA I will use for this section is the 200dSMA since it provides a longer-term technical outlook, is not as swayed by short-term price fluctuations and is widely accepted as reliable for acting as support and resistance areas.


As per this chart for Elementis (LSE:ELM), we can see several instances (within an overall uptrend) where the 200dSMA acted as support for the share price. Indeed, at each of these several areas investors have reacted to a drop in the share price to the 200dSMA line as a buying signal in the anticipation that the uptrend will continue. They are essentially viewing the declines to the 200dSMA as a healthy pullback against a backdrop of long-term positivity.

However, there are also two zones where the 200dSMA has acted as resistance; notice how it can swap between support and resistance, just like with round-number levels and trend lines. For the first zone where the 200dSMA was resistance in late 2011, there is a key point to note. A buy signal can be seen When the moving average is relatively flat, and the share price breaks above it. Likewise, the second zone in late 2014 sees the share price fall below the 200dSMA when the moving average was flat, meaning that the moving average has started trending down perhaps indicating the start of a medium-term downtrend. That can be seen as a sell signal.

In essence, the 200dSMA can be used to identify breakouts from periods of trend consolidation.

However, also note that there are four black rectangles where the share price has broken down below the moving average and the moving average has not acted as support. Therefore it is not a hard and fast rule that the share price has to bounce at the 200dSMA and it's worth looking back to see how the share price reacted as it trended towards the 200dSMA in the past.

As with other technical indicator methods, false breakouts may arise, hence always looked for sustained moves with clear momentum and seek to use both fundamental and other technical analysis methods to support or detract from an expectation.

The Golden Cross and Death Cross

A further technical indicator relating to the two SMAs revolves around how the 50dSMA and 200dSMA move, relative to each other. For this you need to know that the 50dSMA is more responsive to price movements than the 200dSMA given that it is based on fewer days' price action, hence the 50dSMA is more volatile.

A Golden Cross refers to when the 50dSMA passes through and above the 200dSMA and can be considered a buying signal since it could represent the start of an upward trend. On the other hand, a Death Cross refers to when the 50dSMA passes through and below the 200dSMA and can be considered a buying signal since it could represent the start of a downward trend.

Two cases when following these signals would have been a wise move, are shown below for Experian (LSE:EXPN) on the left-hand side, and Man Group (LSE:EMG) on the right-hand side.


However...

Although the two charts above show clear cases where the two crosses have been excellent indicators to follow, it is important to recognise that this is not always the case. Take the example below.


Blindly following the crosses in this case is not the best technique in this instance for BAE Systems (LSE.BA). Although the initial death cross is a good sell signal, the following golden cross is only generated at a level that is around 2% below the initial death cross; once you factor in the spread and commission involved with the trades, that means that there is marginal benefit of selling out at the death cross and buying back at the golden cross.

That said, both crosses are precursors to more significant moves. Should you be able to time the bottom at circa 376p, then you could have identified that the death cross may only be short-term - it is not necessarily a long-term indicator as it was for Experian - and benefit from a more significant move between 376p and 481.7p rather than 422.5p and 481.7p.

It is in this instance that is particularly useful to utilise other indicators, such as the relative strength index or previous levels of support. Equally, it can be very useful to marry up the fundamentals of the business with the technicals such that, if the fundamentals show the company to look 'cheap', then you may identify the pullback as a healthy correction.