I received a great question from #teamtackle for today’s topic. I’m modifying it slightly.
“Are moving averages support and resistance zones? If so, are they better than using price pivots and congestion zones?”
An eye-opening query
To understand my answer requires learning the true definition of support and resistance.
Support
Support is an area where demand is greater than supply. It’s a floor or area where buyers come in to ‘support’ the stock. Said another way, support is an upward move in price. In terms of price it is defined as down, down, up.
5,4,3 = No Support
5,4,3,4,5 = Support at 3
Since market participants have memory, old support zones provide reference points for where buyers might return again.
To find support, look at prior pivots, areas of congestion, or unfilled gaps.
Resistance
Resistance is an area where supply is greater than demand. It’s a ceiling or zone where sellers come in to ‘resist’ a further rise in price. Said another way, resistance is a downward move in price. It is defined as up, up, down.
1,2,3,4 = No Resistance
1,2,3,4,3,2 = Resistance at 4
Since market participants have memory, old resistance zones provide reference points for where sellers might emerge again.
To find resistance, look at prior pivots, areas of congestion, or unfilled gaps.
The principle of polarity says that old ceilings often become new floors and vice versa. Support, once broken, might become a new resistance zone. It works the other way too. Resistance, once broken, might become a new support zone.
Moving Averages
If you look at the definitions above, you’ll find nothing identifying moving averages as support and resistance. That’s because they AREN’T. Instead, they’re imaginary lines drawn on charts that are followed by legions. Their popularity cause to act as gathering grounds for traders. Consider them areas of interest where support or resistance might form, but not support and resistance in and of themselves.
Suppose, for instance, that a stock has a 50-day moving average at $3. Let’s say prices move like so:
5,4,3,2,1
By breaking $3, we officially breached the 50-day moving average. But did we break support? No.
Now, support a prior pivot formed at $3, like so:
5,4,3,4,5,6,5,4,3,2,1
Note how the second time we fell to 3, prices didn’t rise. Instead they continued lower. Thus, we broke support.
Now, just because moving averages don’t automatically fall under the definition of support and resistance doesn’t make them useless. To the contrary, they can be quite helpful in a) clarifying trend direction, b)spotting trend reversals, c)signaling when trends are increasing or decreasing in momentum, and d)signaling where buyers or sellers might emerge.
I’ve written extensively on how you can use moving averages here.
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