Finding Support and Resistance in Moving Averages
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When you watch experts on financial TV talk about the ups and downs of stock prices, you may often catch them referencing the 50-day or 200-day moving average. And when they talk about either, it usually has something to do with the direction of the trend or anticipation of a price bounce:
“Prices are above the 50-day moving average, so the uptrend remains intact.” “Wait for the price to bounce off the 50-day (or 200-day) before you buy.”
Moving averages—particularly the 50-day and 200-day simple moving averages (SMA)—help traders gauge the direction of a trend and serve as support and resistance. We’ll look at MA bounces, why traders expect them, and how to use them in trading.
The chart below shows how price tends to bounce off the moving averages, making them act like support or resistance levels.
Financial media will have you thinking that the 50-day and 200-day SMAs are like the EKGs of the market. But why? Here are a few reasons, and there’s really no magic to it at all.
Popularity contest. The 50-day and 200-day SMAs are popular indicators that can create buying or selling pressure due to crowd mentality.
Market sentiment. Both SMAs are psychological barriers that can affect market sentiment. A stock above its 50-day SMA (or 200-day SMA, depending on the trader) is seen as strong, while a stock below it is seen as weak.
The 200-day is an institutional benchmark. Large institutional investors use the 200-day SMA to benchmark investments. Their actions can move markets, creating significant price reactions.
Measuring trend strength. The 50-day and 200-day SMAs, particularly in combination, help measure trend strength. When the 50-day is above the 200-day and in a full-sail position, it indicates a strong uptrend. When both are flattening, the combination indicates a weakening trend. When the 50-day is below the 200-day in full-sail, it’s a strong downtrend.
Here are a few rules for trading a bounce off either the 50-day SMA or the 200-day SMA.
Step 1—Identify the Uptrend. The 50-day should be above the 200-day. The stronger the upward curve of both MAs and the wider the distance between them, the better. You might also consider using StockCharts’ Technical Rank (SCTR) report (for more info on SCTR, read this).
Step 2—Wait for the Pullback. Wait for the price to pull back toward the 50-day SMA. If price breaks below the 50-day, wait for it to pull closer to the 200-day SMA. You're essentially waiting for the market to take a breather.
Step 3—Spot the Bounce. Look for a bullish price action signal at or near the 50-day SMA (or 200-day SMA). You’re looking for a bounce that has enough momentum to continue upward. In this case, you might want to look at chart patterns and other indicators (such as a Fibonacci retracement or historical support, for example) to confirm the likely strength of the bounce and resumption of the uptrend.
Step 4—Enter a “Long” Position. When and where you buy is up to your preferred strategy. You might buy a breakout of the top of the candle that had the bounce. You might even consider buying right away or at the opening of the next day’s trading session. Your entry point is a personal choice. Equally important, however, are your exit and stop-loss points.
Step 5—Place Your Stop Loss. If you buy a bounce off the 50-day SMA, you might place your stop a few points below the 50-day or the 200-day. But whether you’re buying a bounce off the 50 or 200, you might want to consider levels below the 200-day as your “uncle point” especially if there’s strong historical support or a strong Fib retracement below the 200-day SMA.
Step 6—Determining Your Profit Target. As far as profit targets, this depends on your strategy or personal preference. You may aim for a 2:1 reward-to-risk ratio, a measured move, or a higher resistance level.
In February, Microsoft's stock price rose above both the 50-day and 200-day moving averages, indicating a bearish trend. This rally occurred at the same time as the SCTR score rose above 50.
Notice how the market considered the 50-day simple moving average (SMA) as a support level, as buying occurred every time the price declined towards the line, causing MSFT to bounce off the 50-day SMA. In late July, MSFT prices broke below the highest swing low. In addition to closing below the 50-day SMA, this signaled an end to the short- to intermediate-term uptrend. The key question is whether the price will bounce off the 200-day simple moving average (SMA). If it does, the uptrend could be considered intact. However, if the price closes below the 200-day SMA, it could end the longer-term uptrend, leading to a sideways market, a reversal, or a resumption of the uptrend if the fundamental context supports it.
These rules also apply to going “short” the market. It’s the same rules as above but in reverse.
When navigating the intricate waves of the stock market, traders often look for lighthouses to guide their decisions—and the 50-day and 200-day Simple Moving Averages (SMA) stand tall in this regard. Acting as both gauges of trend direction and psychological barriers, these SMAs wield significant influence over market sentiment and action. Their importance is further underscored by the attention they receive from institutional investors.
By understanding the dynamics of these averages and employing the strategies outlined, both for going long and short, you can enhance your trading toolkit. But as with all trading strategies, you should combine this knowledge with other tools and indicators and always keep risk management in mind. In the end, while the market's waters can be unpredictable, anticipating turning points can certainly help set you on a course for success.
When prices bounced off the 50-day SMA twice, this indicated that a potential bullish reversal was underway. Trading a breakout of the swing high might have made for a good “long” entry point. We also anticipated a event, which would have supported the technical bullish context.
