Using a Moving Average for Buy and Sell Signals - Cabot Wealth Network

Using a Moving Average for Buy and Sell Signals

A stock’s moving average can be a versatile tool to identify institutional trading patterns that can tell you when to buy, sell, or hold.

Traders and investors are perennially on the hunt for the magic formula or indicator that will reel in the stocks destined for nothing but gains. On the flip side, they also want that elusive signal that it’s time to sell at the top and book profits, before a downtrend begins. Of course, both those endeavors fall into the “unicorn” category of imaginary creations which sadly, don’t exist in the real world. However, that doesn’t mean you can’t find easy-to-use technical indicators that can help increase the likelihood of a winning trade or investment. One of the simplest ways to identify strong price performers is with a moving average.

What is a moving average? It’s nothing more than the name implies: The average of data over a pre-determined period of time. It’s used throughout industries to track various forms of data.

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In the stock market, there are several common moving averages that you may find useful. Those include the 10-day, 21-day, 50-day and 200-day moving averages. All of those track the rolling average of closing prices over their designated time periods. Naturally, the measure changes every trading day, as new data are incorporated.

For example, here’s a daily chart for Labcorp (LH). The moving averages are as follows:

  • 10-day: Pink line
  • 21-day: Green line
  • 50-day: Blue line
  • 200-day: Red line

LH-moving-average

On the left side of the chart, going back one year, you can see the stock pulled back in late July, but rather than freefalling, Labcorp found support at its 200-day moving average.

Far from being random, that indicates that institutional investors saw fit to support the stock at those levels by adding to positions at a lower price, or by initiating a new position when the stock was deemed a bargain.

In the distant past, those decisions were solely up to traders and analysts who track stocks’ movements. While that human element is part of the mix today, algorithms and automation play a bigger role.

As the stock picked up steam in early September 2020, it locked into its 10-day average and trended upward along that line until it pulled back from a high of $218.77 in early November.

At this point, the stock found higher lows. In other words, as you see on the chart, it found support along its 50-day line, as fewer institutional investors took profits, with more opting to hold rather than sell.

As you’re seeing, the moving averages give you insight into the decision-making processes of the big institutional holders, like mutual funds, hedge funds, banks, insurance companies and university endowments.

Any kind of moving-average support is an indication that selling has leveled off. But support at a shorter-term average is a signal that it may remain muted. That’s a good thing for individual investors who want to use the moving average as a place to enter a position or add shares, or who want to decide whether to hold or sell.

After trending along what essentially amounted to a convergence of the 10-day, 21-day and 50-day lines until lifting off in January. At that point, the stock gapped higher and trended along its 10-day and 21-day lines until June.

It’s true that moving averages are, by definition, a slightly lagging indicator. That’s not a problem, as you can easily incorporate averages into your buy and sell decisions, as they are excellent gauges of existing trends.

If you are interested in shorter time horizons as a trader, rather than as a long-term or intermediate-term investor, you can use shorter moving averages in your scans. For example, the 5-, 10- and 21-day lines could be your go-to indicators. This will give you signals applying to the more recent past, which can help you with buy decisions. A potential downside, however, is using a short-term average to make a quick sell decision in a temporary pullback.

Watching moving averages for stocks you’re considering, or for those you’re holding, is a good way to eliminate some of the emotion from your decisions, and simply go with what the chart is telling you.

What technical indicators are most important to your buy and sell decisions?

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