Moving average (MA) determines the level of support and resistance generated by price action within a predefined period length, which becomes higher and lower with a broad trend. The long-term average turns more slowly than the short-term average, and the slope determines the technical conditions to increase or decrease the probability of price penetration. The exponential moving average (EMA) changes faster than the simple moving average (SMA) because they are constructed faster.
Compared with testing the falling average line, the price falling from above to test the rising average line is more likely to find support. Compared with testing the rising average line, the price rebound from below to the falling average line is more likely to roll. Multiple moving averages of different period lengths complicate these situations, as some may rise, while others may fall. (Also take a look: How to buy stocks using moving averages.)
The slope of the long-term average changes less frequently than the short-term average. For example, the 20-day moving average can oscillate between rising and falling slopes dozens of times in three months, while the 50-day moving average may move two to three times. At the same time, the 200-day moving average may not change at all, or it may only move up or down once.
This relativity of slope plays a role in chart analysis in two ways. First, the long-term average always imposes greater support or resistance than the short-term average. For example, the support or resistance of the 200-day moving average is more difficult to break than the support or resistance of the 50-day moving average. Second, the slope of the rise and fall will increase or decrease support or resistance, depending on the position of the price relative to the average.
In this hierarchy, when prices are trading above this level, the rising long-term average line provides greater support than the flat or falling average line, and it also generates greater support than the short-term rising or falling average line. On the contrary, when the price is below this level, the falling long-term average line imposes greater resistance than the rising or flat average line, and it also generates greater resistance than the short-term rising or falling average line.
The Dow component Coca-Cola Company (KO) rebounded twice above the 200-day moving average during the 2017 uptrend, and broke through support at the beginning of 2018 and entered a major downtrend. The four rebounds in the next three months reversed at the moving average, which entered a downward direction. The 50-day EMA rolled faster and produced five reversals in the same period. It crossed the 200-day moving average in March and printed a bearish death cross.
Adjust strategy to slope
Prices above the rising long-term and short-term averages will produce a bullish convergence, which is conducive to long strategies, holding larger positions and longer holding periods. This technical alignment is common in uptrends and bull markets. Prices below the rising long-term and short-term averages will produce a bullish divergence, which is conducive to bargain hunting opportunities and value trading. Prices are higher than the average and the slope is opposite to indicate conflict. An increase in the long-term average supports long trading, while a decline in the slope indicates higher environmental risks.
Prices below the falling long-term and short-term averages will produce bearish convergence, increase the power of short-selling strategies, and encourage larger positions and longer holding periods. This kind of technical adjustment is common in downtrends and bear markets. Prices above the falling long-term and short-term averages will produce a bearish divergence, which is conducive to profit taking and short selling. The price is below the average and the slopes are opposite and the signals conflict. A decline in the long-term average supports short trading, while an increase in the slope warns of an imminent bottoming.
These scenarios cover only a small part of the complex interrelationship between price, moving average and slope. Conflict should be welcomed because the intertwined price structure creates a powerful engine for short-term and long-term trading opportunities. However, when the moving average tends to the horizontal direction and converges, when the price starts to oscillate at these narrow levels, please pay attention. This mixed action suggests that high noise levels may herald opportunities: long-term weakness in costs.
Moving averages tend to horizontal trajectories in horizontal markets, reducing their value in trade and investment decisions. Dow component McDonald’s (MCD) was sold at the beginning of 2018 and moved sideways in a volatile pattern for the next four months. During this period, it crisscrossed the 200-day EMA for more than 30 times, sending out multiple waves of false signals. The 50-day EMA is also in a horizontal state, and the price has exceeded its boundary more than ten times. (Also take a look: Understand how transaction management works with the 200-day EMA.)
When the price is higher than the rising long-term and short-term moving averages, actively go long. When prices are below the falling short-term and long-term moving averages, they become aggressive on the short side. When the slopes do not match, or when the price is below the rising average or above the falling average, take defensive measures. (For more reading, please check: Moving average.)