MACD Histogram

The MACD Histogram (MACD-H) consists of vertical bars showing the difference between the MACD line and its signal line . The MACD Histogram is useful for anticipating changes in trend. A change in the MACD-H will usually precede any changes in MACD. Signals are generated by direction, zero line crossovers and divergence from MACD. As an indicator of an indicator, MACD-H should be compared with MACD rather than with the price action of the underlying market. MACD-H is used with MACD as a complementary indicator.

Thomas Aspray found that MACD signals often lagged important market moves, especially when applied to weekly charts. He first experimented with changing the moving averages and found that shorter moving averages did indeed speed up the signals. However, he was looking for a means to anticipate MACD crossovers and came up with the MACD Histogram.

Interpretation

The MACD Histogram represents the difference between MACD and it's signal line (usually the 9-day Exponential Moving Average (EMA) of the MACD). Whenever MACD crosses the signal line, MACD-H crosses the zero line.

• If the MACD line is above the signal line, the histogram is positive, and the bars are drawn above the zero line.
• If the MACD line is below the signal line, histogram is negative, and the bars are drawn below the zero line.

Sharp increases in the MACD-H indicate that MACD is rising faster than its 9-day EMA and upward momentum is strengthening. Sharp declines in the MACD-H indicate that MACD is falling faster than its moving average and downward momentum is increasing. Divergences between MACD and MACD-H are the main tool used to anticipate crossovers. A positive divergence in the MACD-H indicates that MACD is strengthening and could be on the verge of a bullish moving average crossover. A negative divergence in the MACD-H indicates that MACD is weakening and can act to foreshadow a bearish moving average crossover in MACD.

Signals

The main signal generated by the MACD-Histogram is a divergence from MACD followed by a zero-line crossover.

• A bullish signal is generated when a positive divergence forms and there is an upward zero line crossover.
• A bearish signal is generated when there is a negative divergence and a downward zero line crossover.

In Technical Analysis of the Financial Markets, John Murphy states that the real value of the MACD-H is spotting when the spread between the two lines is widening or narrowing. When the histogram is above its zero line (positive) but starts to fall, the uptrend is weakening. Conversely, when the histogram is below its zero line (negative) and starts to rise, the downtrend is losing momentum. These turns of the histogram provide early warnings that the current trend is losing momentum, and the buy or sell signal is given when the histogram crosses the zero line.

Murphy also advocates a two-tiered approach in order to avoid making trades against the major trend. The weekly MACD-H can be used to generate long-term signals. Then only short-term signals that agree with the major trend are used.
• If the long-term trend is up, only positive divergences with upward zero line crossovers are considered valid for the MACD-H.
• If the long-term trend is down, only negative divergences with downward zero line crossovers are considered valid.

Used this way, the weekly signals become trend filters for daily signals. This prevents using daily signals to trade against the overall trend.

How to Trade Using MACD

The MACD indicator is primarily used to trade trends and should not be used in a ranging market. Signals are taken when MACD crosses its signal line, calculated as a 9 day exponential moving average of MACD. The basic MACD trading rule is to sell when the MACD falls below its 9 day signal line and to buy when the MACD rises above the 9 day signal line. Apart from signal line crossovers, traders can look for centerline crossovers and divergences to generate signals.

Signal Line Crossovers

Signal line crossovers are the most common MACD signals. The signal line is a 9-day EMA of MACD. As a moving average of the indicator, it trails MACD and makes it easier to spot turns in MACD. A bullish crossover occurs when MACD turns up and crosses above the signal line. A bearish crossover occurs when MACDturns down and crosses below the signal line. Crossovers can last a few days or a few weeks, it all depends on the strength of the move.

Signal crossovers are quite common. As such, due diligence is required before relying on these signals.Signal line crossovers at positive or negative extremes should be viewed with caution.It takes a strong move in the underlying security to push momentum to an extreme. Even though the move may continue, momentum is likely to slow and this will usually produce a signal line crossover at the extremities. Volatility in the underlying security can also increase the number of crossovers.

Below Chart shows IBM with its 12-day EMA (green), 26-day EMA (red) and MACD (12,26,9) in the indicator window. There were eight signal line crossovers in six months: four up and four down. There were some good signals and some bad signals. The yellow area highlights a period when MACD surged above 2 to reach a positive extreme. There were two bearish signal line crossovers in April and May, but IBM continued trending higher. Even though upward momentum slowed after the surge, upward momentum was still stronger than downside momentum in April and May. The third bearish signal line crossover in May resulted in a good signal.

Centerline Crossovers

MACD oscillates above and below the zero line, which is also known as the centerline. Centerline crossovers are the next most common MACD signals. These crossovers signal that the 12-day EMA has crossed the 26-day EMA. The direction, of course, depends on direction of the moving average cross. A bullish centerline crossover occurs when MACD moves above the zero line to turn positive.This happens when the 12-day EMA of the underlying security moves above the 26-day EMA. A bearish centerline crossover occurs when MACD moves below the zero line to turn negative.This happens when the 12-day EMA moves below the 26-day EMA.

Centerline crossovers can last a few days or a few months. It all depends on the strength of the trend.MACD will remain positive as long as there is a sustained uptrend. MACD will remain negative when there is a sustained downtrend.Above Chart shows Pulte Homes (PHM) with at least four centerline crosses in nine months. The resulting signals worked well because strong trend emerged soon thereafter.

Below Chart shows 3M (MMM) with a bullish centerline crossover in late March 2009 and a bearish centerline crossover in early February 2010. This signal lasted 10 months. In other words, the 12-day EMA was above the 26-day EMA for 10 months. This was one strong trend.

DIVERGENCES

DIVERGENCES FORM WHEN MACD DIVERGES FROM THE PRICE ACTION OF THE UNDERLYING SECURITY. A BULLISH DIVERGENCE FORMS WHEN A SECURITY RECORDS A LOWER LOW AND MACD FORMS A HIGHER LOW. THE LOW LOWER IN THE SECURITY AFFIRMS THE CURRENT DOWNTREND, BUT THE HIGHER LOW IN MACD SHOWS LESS DOWNSIDE MOMENTUM. THE SLOWING OF THE DOWNTREND SOMETIMES FORESHADOWS A TREND REVERSAL OR A SIZABLE RALLY.

BELOW CHART SHOWS GOOGLE (GOOG) WITH A BULLISH DIVERGENCE IN OCTOBER-NOVEMBER 2008. THE MACD MOVING AVERAGES ARE BASED ON CLOSING PRICES AND WE SHOULD CONSIDER CLOSING PRICES IN THE SECURITY AS WELL. NOTICE THAT THERE WERE CLEAR REACTION LOWS IN OCTOBER AS GOOGLE BOUNCED FOR A FEW WEEKS AND MACD MOVED ABOVE ITS SIGNAL LINE.MOREOVER,MACDFORMED A HIGHER HIGH AS GOOGLE FORMED A LOWER LOW IN NOVEMBER. THIS BULLISH DIVERGENCE WAS CONFIRMED WITH A SIGNAL LINE CROSSOVER IN EARLY DECEMBER.

A BEARISH DIVERGENCE FORMS WHEN A SECURITY RECORDS A HIGHER HIGH AND MACD FORMS A LOWER HIGH. THE HIGHER HIGH IN THE SECURITY IS NORMAL FOR AN UPTREND, BUT THE LOWER HIGH IN MACD SHOWS LESS UPSIDE MOMENTUM. WANING UPWARD MOMENTUM CAN SOMETIMES FORESHADOW A TREND REVERSAL OR SIZABLE DECLINE.

BELOW CHART SHOWS GAMESTOP (GME) WITH A LARGE BEARISH DIVERGENCE FROM AUGUST TO OCTOBER. THE STOCK FORGED A HIGHER HIGH ABOVE 28, BUT MACD FELL SHORT OF ITS PRIOR HIGH AND FORMED A LOWER HIGH. THE SUBSEQUENT SIGNAL LINE CROSSOVER AND SUPPORT BREAK IN MACD WERE BEARISH. TURNING BACK TO THE GME PRICE CHART, NOTICE HOW BROKEN SUPPORT TURNED INTO RESISTANCE ON THE THROWBACK BOUNCE IN NOVEMBER (RED DOTTED LINE). THIS THROWBACK PROVIDED A SECOND CHANCE TO SELL OR SELL SHORT.

DIVERGENCES SHOULD BE TAKEN WITH CAUTION. BEARISH DIVERGENCES ARE COMMONPLACE IN A STRONG UPTREND, WHILE BULLISH DIVERGENCES OCCUR OFTEN IN A STRONG DOWNTREND. UPTRENDS OFTEN START WITH A STRONG ADVANCE THAT PRODUCES A SURGE IN UPSIDE MOMENTUM (MACD). EVEN THOUGH THE UPTREND CONTINUES, IT CONTINUES AT A SLOWER PACE THAT CAUSESMACD TO DECLINE FROM ITS HIGHS. THE OPPOSITE OCCURS AT THE BEGINNING OF A STRONG DOWNTREND.

CONCLUSIONS

MACD IS SPECIAL BECAUSE IT BRINGS TOGETHER MOMENTUM AND TREND IN ONE INDICATOR. THIS MEANSMACD WILL NEVER BE FAR REMOVED FROM THE ACTUAL PRICE MOVEMENTS OF THE UNDERLYING SECURITY. THIS UNIQUE BLEND OF TREND AND MOMENTUM CAN BE APPLIED TO DAILY, WEEKLY OR MONTHLY CHARTS. MACD IS NOT PARTICULARLY GOOD FOR IDENTIFYING OVERBOUGHT AND OVERSOLD LEVELS. EVEN THOUGH IT IS POSSIBLE TO IDENTIFY LEVELS THAT ARE HISTORICALLY OVERBOUGHT OR OVERSOLD, MACD DOES NOT HAVE ANY UPPER OR LOWER LIMITS TO BIND ITS MOVEMENT. MACD CAN CONTINUE TO OVEREXTEND BEYOND HISTORICAL EXTREMES DURING SHARP MOVES.

Moving Average Convergence-Divergence (MACD)

Introduction

Developed by Gerald Appel in the late seventies, Moving Average Convergence-Divergence (MACD) is one of the simplest and most effective momentum indicators available. The MACD indicator is basically a refinement of the two moving averages system and measures the distance between the two moving average lines. It turns two trend-following indicators (moving averages), into a momentum oscillator by subtracting the longer moving average from the shorter moving average. As a result, MACD offers the best of both worlds: trend following and momentum. MACD fluctuates above and below the zero line as the moving averages converge, cross and diverge. Traders can look for signal line crossovers, centerline crossovers and divergences to generate signals. Because MACD is unbounded, it is not particularly useful for identifying overbought and oversold levels.

Calculation

MACD: (12-day EMA - 26-day EMA)

Signal Line: 9-day EMA of MACD

MACD Histogram: MACD - Signal Line

Standard MACD is the 12-day Exponential Moving Average (EMA) less the 26-day EMA. Closing prices are used for these moving averages. A 9-day EMA of MACD is plotted along side to act as a signal line to identify turns in the indicator. The MACD -Histogram represents the difference between MACD and its 9-day EMA, the signal line. The histogram is positive when MACD is above its 9-day EMA and negative when MACD is below its 9-day EMA.

In the chart above, the black line (MACD) is the moving average of the difference between the 12 and 26-period moving averages. The red line (Signal Line) plots the average of the last 9 periods of the black line (MACD). This smoothens out the MACD even more, which gives us a more accurate line. The histogram simply plots the difference between the MACD and the Signal Line.

If you look at above chart, you can see that, as the MACD and the Signal Line separate, the histogram gets bigger. This is called divergence because the faster moving average is "diverging" or moving away from the slower moving average. As the moving averages get closer to each other, the histogram gets smaller. This is called convergence because the faster moving average is "converging" or getting closer to the slower moving average. Hence it got the name, Moving Average Convergence Divergence.

COMMONLY USED MOVING AVERAGES

Moving averages are a powerful tool for analyzing the trend in a security. They provide useful support and resistance points and are very easy to use. The most common time frames that are used when creating moving averages are the 200-day, 100-day, 50-day, 20-day and 10-day. The 200-day average is thought to be a good measure of a trading year, a 100-day average of a half a year, a 50-day average of a quarter of a year, a 20-day average of a month and 10-day average of two weeks.

Shorter moving averages will be more sensitive and generate more signals. However, there will also be an increase in the number of false signals and whipsaws. Longer moving averages will move slower and generate fewer signals. These signals will likely prove more reliable, but they also may come late. The EMA, which is generally more sensitive than the SMA, will also be likely to generate more signals. Each investor or trader should experiment with different moving average lengths and types to examine the trade-off between sensitivity and signal reliability. Once you have found a combination that works for you, then stick by it so you get a feel for the signals that those particular averages generate. There is no one moving average or combination with a special power; the key point is to represent the moving averages in various, multiple time frames.

THREE MOVING AVERAGES COMBINATION

Most traders use the combination of three averages. By combining multiple moving averages, you'll be able to come up with a clear answer to what the trend is in different time frames and whether the trends in the different time frames are aligned with one another. Futures traders use the combination like 5, 10 and 20 period averages. Stock traders use longer periods like the 50 day, 100 day and 200 day to generate trading signals. When the short period average crosses the medium one, this gives a trading signal but this need to be confirmed. Confirmation is obtained when the short and the medium move above the longer period average.

For short, medium or long term trades, one can use the combination of 20 and 50 period Exponential Moving Average (EMA) and the 200 period Simple Moving Average (SMA). Combining moving averages from multiple time frames will allow you to determine when the trends from all three periods are in your favor. By synthesizing all of these various moving averages, you will greatly increase your chances of profitable trading.

THE 20 & 50 PERIOD MOVING AVERAGES

The 20 and 50 EMAs track the prices closer and help in determining structure (uptrend/downtrend) .They also aid in developing low-risk, high probability trade set-ups (entries) in a trending environment (for example, buying pullbacks to the 20 or 50 EMA in a rising trend.). You can see in the chart below how these lines can help you define trends. On the left side of the chart the 20 EMA is above the 50 EMA and the trend is up. The 20 EMA crosses down below the 50 EMA (after May 10) and the trend is down. Then, the 20 EMA crosses back up through the 50 EMA (in September 10) and the trend is up again - and it stays up thereafter. Focus on long positions only when the 20 EMA is above the 50 EMA. Focus on short positions only when the 20 SMA is below the 50 EMA. It doesn't get any simpler than that and it will keep you on the right side of the trend.

Here are the important things to remember (for long positions - reverse for short positions.):

Ø The 20 SMA must be above the 50 EMA.

Ø Their must be plenty of space in between the moving averages.

Ø Both moving averages must be sloping upward.

THE 200 PERIOD MOVING AVERAGE

The 200 SMA is the most important moving average to have on a stock chart. The 200 SMA is used to separate bull territory from bear territory. Studies have shown that by focusing on long positions above this line and short positions below this line can give you a slight edge. Also, many funds follow the 200 day or week SMA and that might be all the technical analysis they use, so it tends to cause ‘reactions’ and is an important level to watch. You will be surprised at how many times a stock will reverse in this area (look at the chart above).

Moving averages are one of the most powerful trend-following tools available to the trader. But they only work well when a stock is trending - not when they are in a trading range. When a stock (or the market itself) becomes "sloppy" then you can ignore moving averages - they won't work. Moreover, they should not be used in isolation. Instead, you should use moving averages in conjunction with Chart Pattern Analysis, Candlesticks and indicators such as MACD and Stochastics to create powerful and profitable Technical Analysis.

Moving Average - Crossovers

Moving average crossovers are an important tool in the arsenal of any trader. Moving Average Convergence Divergence (MACD) one of the most popular indicator depends on them. Crossovers mark important shifts in momentum and support/resistance regardless of holding period. Many traders can therefore just stick with the major averages and find out most of what they need to know. The most popular settings draw charts with a 20-day for the short-term trend, a 50-day for the intermediate trend and a 200-day for the big picture. Long-term crossovers carry more weight than short-term events.

However, when trading with these crossovers, you should know this that these averages are lagging indicators. What this means is that they are giving a signal about the past price action something that has already taken place. These averages work very well in a trending market but do not work well in non trending or choppy markets.

Major types of Crossovers are Price Crossover, Double Moving Average Crossover and Triple Moving Average Crossover.

Price Crossover

Moving Averages can be used to generate signals with simple price crossovers. A bullish signal is generated when prices move above the Moving Average. A bearish signal is generated when prices move below the Moving Average. Price crossovers can be combined to trade within the bigger trend. The longer Moving Average sets the tone for the bigger trend and the shorter Moving Average is used to generate the signals. One would look for bullish price crosses only when prices are already above the longer Moving Average. This would be trading in harmony with the bigger trend. For example, if price is above the 200-day Moving Average, chartists would only focus on signals when price moves above the 50-day Moving Average. Obviously, a move below the 50-day Moving Average would precede such a signal, but such bearish crosses would be ignored because the bigger trend is up. A bearish cross would simply suggest a pullback within a bigger uptrend. A cross back above the 50-day Moving Average would signal an upturn in prices and continuation of the bigger uptrend.

Chart given below shows Emerson Electric (EMR) with the 50-day EMA and 200-day EMA. The stock moved above and held above the 200-day Moving Average in August. There were dips below the 50-day EMA in early November and again in early February. Prices quickly moved back above the 50-day EMA to provide bullish signals (green arrows) in harmony with the bigger uptrend.

Double Moving Average Crossover

Two Moving Averages can be used together to generate crossover signals. In Technical Analysis of the Financial Markets, John Murphy calls this the "double crossover method". Double crossovers involve one relatively short Moving Average and one relatively long Moving Average. As with all Moving Averages, the general length of the Moving Average defines the timeframe for the system. A system using a 5-day EMA and 35-day EMA would be deemed short-term. A system using a 50-day SMA and 200-day SMA would be deemed medium-term, perhaps even long-term.

When using double moving average crossover as a technical indicator, you should be long when the short average is above the longer period average. And when it is below, you should be short. The crossovers of these short and longer averages provide the trading signal to act as they indicate that the momentum is shifting from one direction to another.

A bullish crossover occurs when the shorter Moving Average crosses above the longer Moving Average. This is also known as a golden cross. A bearish crossover occurs when the shorter Moving Average crosses below the longer Moving Average. This is known as a dead cross. The Golden Cross represents a major shift from the bears to the bulls. It triggers when the 50-day average breaks above the 200-day average. Conversely, the Death Cross restores bear power when the 50-day falls back beneath the 200-day. The 200-day average becomes major resistance after the 50-day average drops below it, and major support after breaking above it. When price gets trapped between the 50-day and 200-day averages, it can whipsaw repeatedly between their price extremes. This pinball action marks a zone of opportunity for swing trades.

The chart below of the S&P Depository Receipts Exchange Traded Fund (SPY) shows the 50-day Simple Moving Average and the 200-day Simple Moving Average; this Moving Average pair is often looked at by big financial institutions as a long range indicator of market direction.

Note how the long-term 200-day Simple Moving Average is in an uptrend; this is a signal that the market is quite strong. Generally, a buy signal is established when the shorter-term 50-day SMA crosses above the 200-day SMA and contrastly, a sell signal is indicated when the 50-day SMA crosses below the 200-day SMA.

In the chart above of the S&P 500, both buy signals would have been extremely profitable, but the one sell signal would have caused a small loss. Keep in mind, that the 50-day, 200-day Simple Moving Average crossover is a very long-term strategy.

Triple Moving Average Crossover

The triple moving average crossover system is also used to generate buy and sell signals. Its buy signals come early in the development of a trend, and its sell signals are generated early when a trend ends. The third moving average can be used in combination with the other two moving averages to confirm or deny the signals that they generate. It thereby reduces the chance that the investor will be acting on false signals.

The shorter the moving average, the more closely it will follow the price trend. When a stock begins an uptrend, short-term moving averages will begin rising far earlier than longer-term moving averages. For example, if a stock declines by equal amounts each day for 50 days, and then begins to rise by the same amount each day for 50 days, the 5-day moving average will start to rise on the third day after the change in direction, the 10-day average will begin to rise on the sixth day after the change, and the 20-day average will begin to rise on the eleventh day. The longer a trend has persisted, the more likely it is to continue persisting, up to a point. Waiting too long to enter a trend can result in missing most of the gain. Entering the trend too early can mean entering on a false start and having to sell at a loss. Traders have addressed this problem by waiting for three moving averages to verify a trend by aligning in a certain way.

To illustrate, we’ll use the 5-day, 10-day, and 20-day moving averages. When an uptrend begins, the 5-day moving average will start rising first. Traders view this as interesting but of no major significance. As the upside momentum increases, longer moving averages gradually begin to follow suit.

A buying alert takes place when the 5-day crosses above both the 10 and the 20. That is, the average price of the stock over the last five days is greater than its average over both the last ten days and the last twenty days. This shows a short-term shift in trend. A buy signal is confirmed when the 10-day then crosses above the 20-day. The 10-day average price of a stock is more meaningful than the 5-day average price. If the average price over the last ten days is greater than the average price over the last twenty days, the shift in momentum is considered to be much more significant.

Conversely, when an uptrend changes to a downtrend, the first thing that happens is that the 5-day declines below the 10-day and 20-day averages. This constitutes an alert that a sell signal may be forthcoming. The confirmed sell signal occurs when the 10-day crosses below the 20-day resulting in an alignment in which the 5-day average is below the 10-day average and the 10-day average is below the 20-day average.

Investors and traders might be wise to incorporate another indicator into their decision-making. To increase the reliability of the signals given by the system outlined above, it might be wise to use the 50-day moving average as a context and reference. The best and most profitable time to buy a stock is early in a new trend. Later buy signals carry greater risk that the stock will soon decline (because stocks don’t go up forever). Therefore, if the 50-day average has been in a significant decline and is now leveling off or just beginning to rise, a buy signal using the triple crossover method outlined above has a greater chance of success than if the 50-day average has been rising for a long time, or is beginning to level off or decline after a prolonged advance. In other words, the intermediate-term 50-day average can be used to confirm and "support" the signals given by the shorter-term moving averages. Generally, it's better to avoid buying a stock if its 50-day moving average is in decline. A short-term trader might make an exception to this general policy in order to profit from a snap-back toward the declining 50-day average from an extreme oversold condition.

An example of triple moving average crossover is shown in the chart below of Wal-Mart (WMT) stock. The first crossover of the quickest SMA (in the example above, the 10-day SMA) across the next quickest SMA (20-day SMA) acts as a warning that prices are reversing trend; however, usually a buy or sell order is not placed yet. The second crossover of the quickest SMA (10-day) and the slowest SMA (50-day) finally triggers the buy or sell signal. A more conservative approach is to wait until the middle SMA (20-day) crosses over the slower SMA (50-day).

Limitations of Crossovers

Moving Averages Crossovers add horsepower to many types of trading strategies. But try to limit their use to trending markets. They work best in trending markets, where an uptrend or downtrend is firmly in place, but they generate many false signals in choppy, sideways markets. Moving averages emit false signals during the "negative feedback" of sideways markets. Keep in mind these common indicators measure directional momentum. They lose power in markets with little or no price change.

Moving Averages crossovers produce relatively late signals. After all, the system employs two lagging indicators. Moving Averages are lagging indicators because they use historical information. Using them as indicators will not get you in at the bottom and out at the top but will get you in and out somewhere in between. The longer the Moving Average periods, the greater the lag in the signals. These signals work great when a good trend takes hold. However, a Moving Average crossover system will produce lots of whipsaws in the absence of a strong trend.

For years, technicians have tried to filter crossover systems through trend-recognition formulas in order to reduce whipsaws. You can try this for yourself, or just look for price patterns that tell you the crossovers are worthless. Take a look at a chart of any market with a strong trend. You will see that the moving averages are not crossing back and forth repeatedly. They will be moving in the same general direction in a more or less parallel fashion. Now look at a chart of a non-trending market. As this market moves sideways the moving averages will be crossing back and forth very frequently. Look at the implications of this simple examination of the charts. If we are trading the crossovers we will be trading most frequently in non-trending markets and trading most infrequently in strongly trending markets.

With a little thought and effort I’m sure we can design some reliable entry signals that are based on moving averages but avoid the typical crossover signals. For example we could measure the slope of several moving averages and when all the averages slope upward we would have a buy signal.We could also measure the distance between several moving averages and implement our trades when the averages are all headed in the same direction but start getting farther apart. This procedure would give us a series of entry signals within the same original trend. This should provide an excellent entry and re-entry strategy.

Persistent rangebound markets limit the usefulness of all types of average information. All moving averages eventually converge toward a single price level in dead markets. This flatline behavior yields few clues about market direction. So stop using averages completely when this happens, and move to oscillators (such as Stochastics) to predict the next move.

Major Uses of Moving Averages

Moving averages are the basis of chart and time series analysis. Simple moving averages and the more complex exponential moving averages help visualize the trend by smoothing out price movements. Charting analysis can be traced back to 18th Century Japan, yet how and when moving averages were first applied to market prices remains a mystery. It is generally understood that simple moving averages (SMA) were used long before exponential moving averages(EMA), because EMAs are built on SMA framework and the SMA continuum was more easily understood for plotting and tracking purposes.

Some of the primary functions of moving averages are to identify current trends and trend reversals, measure the strength of an asset's momentum and determine potential areas where an asset will find support or resistance.

Trend Identification

Identifying trends is one of the key functions of moving averages, which are used by most traders who seek to "make the trend their friend". Moving averages are lagging indicators, which means that they do not immediately predict new trends, but confirm trends once they have been established. A stock is deemed to be in an uptrend when the price is above a moving average and the average is sloping upward. Many traders will only consider holding a long position in an asset when the price is trading above a moving average whereas he will use a price below a downward sloping average to confirm a downtrend. This simple rule can help ensure that the trend works in the traders' favor. As you can see in the Figure given below, when a moving average is heading upward and the price is above it, the security is in an uptrend. Conversely, a downward sloping moving average with the price below signals a downtrend.

Another method of determining trend is to look at the order of a pair of moving averages. When a short-term average is above a longer-term average, the trend is up. On the other hand, a long-term average above a shorter-term average signals a downward movement in the trend.

Trend Reversal

Moving average trend reversals are formed in two main ways: when the price moves through a moving average and when it moves through moving average crossovers. The first common signal is when the price moves through an important moving average. For example, when the price of a security that was in an uptrend falls below a 50-period moving average, like in the Figure given below, it is a sign that the uptrend may be reversing.

The other signal of a trend reversal is when one moving average crosses through another. For example, as you can see in the Figure given below, if the 15-day moving average crosses above the 50-day moving average, it is a positive sign that the price will start to increase.

If the periods used in the calculation are relatively short, for example 15 and 35, this could signal a short-term trend reversal. On the other hand, when two averages with relatively long time frames cross over (50 and 200, for example), this is used to suggest a long-term shift in trend.

Momentum

Many beginner traders ask how it is possible to measure momentum and how moving averages can be used to tackle such a feat. The simple answer is to pay close attention to the time periods used in creating the average, as each time period can provide valuable insight into different types of momentum. In general, short-term momentum can be gauged by looking at moving averages that focus on time periods of 20 days or less. Looking at moving averages that are created with a period of 20 to 100 days is generally regarded as a good measure of medium-term momentum. Finally, any moving average that uses 100 days or more in the calculation can be used as a measure of long-term momentum. Common sense should tell you that a 15-day moving average is a more appropriate measure of short-term momentum than a 200-day moving average.

One of the best methods to determine the strength and direction of an asset's momentum is to place three moving averages onto a chart and then pay close attention to how they stack up in relation to one another. The three moving averages that are generally used have varying time frames in an attempt to represent short-term, medium-term and long-term price movements. In the Figure given below, strong upward momentum is seen when shorter-term averages are located above longer-term averages and the two averages are diverging. Conversely, when the shorter-term averages are located below the longer-term averages, the momentum is in the downward direction.

Support and Resistance

Another major way in which moving averages are used is to identify support and resistance levels. Moving averages act as a support in an uptrend and resistance in a downtrend. It is not uncommon to see a stock that has been falling stop its decline and reverse direction once it hits the support of a major moving average. Many traders anticipate a "bounce off" of major moving averages and use other technical indicators as confirmation of the expected move.

A short-term uptrend might find support near the 20-day simple moving average, which is also used in Bollinger Bands. A long-term uptrend might find support near the 200-day simple moving average, which is the most popular long-term moving average. If fact, the 200-day moving average may offer support or resistance simply because it is so widely used. It is almost like a self-fulfilling prophecy.

However a move through a major moving average is often used as a signal by technical traders that the trend is reversing and once the price of an asset falls below an influential level of support, such as the 200-day moving average, it is not uncommon to see the average act as a strong barrier that prevents investors from pushing the price back above that average. Hence, what was acting as a major support in an uptrend is now a major resistance. This resistance is often used by traders as a sign to take profits or to close out any existing long positions. Many short sellers will also use these averages as entry points because the price often bounces off the resistance and continues its move lower.

Below chart shows the NY Composite with the 200-day simple moving average from mid 2004 until the end of 2008. The 200-day provided support numerous times during the advance. Once the trend reversed with a double top support break, the 200-day moving average acted as resistance around 9500.

The support and resistance characteristics of moving averages make them a great tool for managing risk. The ability of moving averages to identify strategic places to set stop-loss orders allows traders to cut off losing positions before they can grow any larger. As you can see in the below Figure, traders who hold a long position in a stock and set their stop-loss orders below influential averages can save themselves a lot of money. Using moving averages to set stop-loss orders is key to any successful trading strategy.

Limitations of Using Moving Averages

The advantages of using moving averages need to be weighed against the disadvantages. Moving averages are trend following, or lagging, indicators that will always be a step behind. This is not necessarily a bad thing though. After all, the trend is your friend and it is best to trade in the direction of the trend. Moving averages insure that a trader is in line with the current trend. Even though the trend is your friend, securities spend a great deal of time in trading ranges, which render moving averages ineffective. Once in a trend, moving averages will keep you in, but also give late signals. Don't expect to sell at the top and buy at the bottom using moving averages. As with most technical analysis tools, moving averages should not be used on their own, but in conjunction with other complementary tools. Chartists can use moving averages to define the overall trend and then use RSI to define overbought or oversold levels.