Last update: August 2021

Last week, we introduced you to the mighty moving average indicator. Today, we’re continuing our exploration by focusing on momentum, trend reversals, and support/resistance.

Momentum

Momentum is typically expressed as the distance between pivots. In an uptrend, we look at the pivot highs. In a downtrend, we use the pivot lows. If the distance is expanding, then momentum is increasing. If it’s contracting, then momentum is decreasing.

Moving averages can help confirm these momentum signals, albeit with a lag. When momentum increases, shorter-term moving averages rise faster than longer-term moving averages, thus increasing the gap between them.

When momentum decreases, the rise in shorter-term moving averages slows down before the rise in longer-term moving averages, which shrinks the gap between them.

On a side note, this is one of the dynamics that drives the MACD indicator.

Floors and Ceilings

By definition, support is an area where demand > supply. It is a floor and is confirmed by an upward move in price. Resistance is an area where supply > demand. It is a ceiling and is confirmed by a downward move in price. Moving averages by themselves are not support or resistance, but they are often a gathering ground for buyers and sellers.

Consider these areas of interest where support and resistance often end up forming. This is why we view pullbacks in an uptrend toward the rising 20-day or 50-day moving averages as potential buying opportunities.

Alternatively, rallies in a downtrend toward the descending 20-day or 50-day moving averages are potential shorting opportunities.

Reversals

Moving averages can also help spot with a trend is reversing. Specifically, this happens when the price of a stock breaks a moving average. Breaking above the average would signal a bullish reversal while breaking below would indicate a bearish reversal.

For this, I suggest using a longer-term moving average, such as the 50 MA. I’ve found using the 20-day or other short-term moving average results in too many signals. It’s just too noisy. Here’s the SPY with a 50 MA. I’ve highlighted the buy signals in green and sell signals in red.

You’ll notice that good things happen above the 50 MA and bad things happen below the 50 MA. Now, not all signals are perfect. There have been many times over the past two years that a break below the 50 MA would have turned you bearish, only to see the stock pop right back above the 50 MA and generate a bullish signal. No signal works all the time. But it’s still been a valuable metric to use that keeps you on the right side of the primary trend.

• When above the 50 MA, the path of least resistance as up. The market is innocent until proven guilty.
• When below the 50 MA, the path of least resistance is down. The market is guilty until proven innocent.

Next week in our final installment of this series we’ll explore moving average crossovers.

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