MOVING AVERAGES

Moving averages represent one of the simplest and most powerful technical analysis tools available to the swing trader. When I discuss moving averages in my stock market seminars, almost all traders are aware of moving averages, yet few know their subtleties and sometimes even their basic trading signals.

With this issue of the StreetAuthority Swing Trader I am going to start a multi-part series on using moving averages. First, I want to discuss with you the calculation and purpose of moving averages. Next, I want to illustrate the six major "directions" of moving averages in relation to price, as well as the difference between a simple and an exponential moving average.

Swing traders should be aware of the time frames of moving averages relevant to them and how to synthesize the different messages given by these time frames. I also want to discuss signals given when a stock is very far off of a key moving average.

The calculation of a moving average is very simple. Let's say we wanted to hand calculate a four-day simple moving average of the following closing prices: $13.00, $13.50, $14.00, $14.50 and $15.00. If we add the first four numbers in this series we would get a total of 55. That number divided by four gives us $13.75.

Imagine drawing a simple chart; we would now have four closing prices. We could then represent the moving average number with a dashed line, which we would place at day four at $13.75.

If we now wanted to calculate day five, we would perform a simple trick. All we need to do is add 15 (the close of day five) to 55 and then subtract the first close of 13. This calculation is: 55 + 15 – 13 = 57. After dividing by the moving average period (in this case, four), this would give us a dashed moving average point for day five at $14.25. Note that in this simple example, the slope of the moving average is rising. In addition, note that that this rising moving average is below the stock's current price. As we shall soon see, that is the "signature" of an uptrend.

Note that moving averages "move" -- hence their name. Over time, they provide a picture of the overall trend. One experiment worth doing is to mentally eliminate price from the chart. What that leaves you with is the moving average line, which is the "true trend" for that period.

Moving averages are simple, yet very powerful, trend-following tools. Whereas a trendline is straight, moving averages may be thought of as curved trendlines. Like trendlines, they provide support and resistance. Like trendlines, they communicate very important messages about future price behavior when they are tested and price holds, or when they are tested and prices reverse. Swing traders who wish to be successful should not violate the trend (as indicated by moving averages relevant to the swing trading time frame). You can occasionally bet against the moving averages and win, but typically your victory will be short-lived.

Below you'll see a chart of MCDATA -- a stock on our "Watch List." Along with the basic price chart, I've added a simple 30-day moving average. I want to discuss the six basic messages a single, simple moving average can give in relation to price.

First, a moving average can, like price, slope in one of three directions: up, down or sideways. Second, it can either be above or below price. (Occasionally price will "hug" the moving average, but typically that is very short-lived.)

Here is a description of the six major relationships between price and a moving average. Note them carefully, as they often provide important clues to future price direction.

1. PRICE IS BELOW A DECLINING MOVING AVERAGE.
   This configuration can be observed on the MCDTA chart from late August to early October. When price is below a downward-sloping moving average, swing traders should look for opportunities to go short.
   Notice point #1 on this chart. Early in the decline MCDTA hit psychological support at $7.50 and then bounced up toward the declining 30-day moving average. Typically these bounces fail, and this time was no exception.
   
2. PRICE IS ABOVE A DECLINING MOVING AVERAGE.
   This pattern can be observed in late October at the point marked #2. When price is above a declining moving average, we are receiving a warning that a potential change in trend may be developing. However, it is usually early in the trend change process and a swing trader who acts on such a signal must trade very nimbly. Typically, prices will correct back toward the moving average.
   
3. PRICE IS BELOW A SIDEWAYS MOVING AVERAGE.
   A sideways moving average suggests that a period of consolidation is taking place. Rapid-fire swing trading is possible during these periods, as price will likely rise back up to and above the sideways moving average. This type of pattern can be seen in MCDTA in late December at point #3.
   
4. PRICE IS ABOVE A SIDEWAYS MOVING AVERAGE.
   At point #4, MCDTA created what appeared to be a breakaway gap from a symmetrical triangle on very high volume. Perhaps the only clue that the swing trader should be cautious was the sideways moving average. Prices subsequently retreated and this gap was eventually filled.
   
5. PRICE IS ABOVE A RISING MOVING AVERAGE. (THIS IS THE SIGNATURE BULLS SHOULD RECOGNIZE.)
   Price, as we have seen, can be above a falling or sideways moving average. Buying those configurations is much more speculative than buying when the moving average is sloping upward and price is staying consistently above it. Note the hammer candle at point #5 in mid-April. Prices temporarily broke below the rising moving average on an intraday basis, but closed above it.
   
6. PRICE IS BELOW A RISING MOVING AVERAGE.
   Typically, this signature provides a good buying opportunity. To make sure the swing trader is not buying as the stock is beginning to reverse, he or she might wait until the stock trades back above the moving average before going long.

Note that at this chart's end, MCDTA is consolidating within a narrow rectangle after having broken out of major resistance near $11. As I discussed in this newsletter several weeks ago, MCDTA appears to be in a flag formation. A break above resistance at $15.10 should send the stock toward the $17 area rather quickly. Note that MCDTA continues to trade above a rising trendline and that at point #7, the shares tested a rising moving average and bounced higher.

Income Security of the Month Our "Income Security of the Month" for August 2008 invests in a fast-growing overseas market that doesn't get much exposure in the mainstream financial press. And although it typically makes enormous annual dividend payments -- it has paid an average dividend of 25.5% per year over the past five years -- this fund is perhaps most appealing for its total return potential. Specifically, the fund has delivered total returns of +178.9% since 2003, and it ranks in the top 10% of its category over the past decade.

Top 10 Stocks for 2008! Since we began publishing this report back in 2003, the picks we've featured have consistently beaten the broader market -- delivering average gains of +21.3% per year and outperforming the S&P by a nearly 2-to-1 margin. Act now to reserve your copy of our newest report -- Top Ten Stocks for 2008.