PDF Summary:Moving Averages 101, by Steve Burns and Holly Burns

Moving averages are a fundamental technical analysis tool for identifying trends and potential opportunities in the market. In Moving Averages 101, authors Steve Burns and Holly Burns explore the ins and outs of utilizing different types of moving averages—simple, exponential, and weighted—to smooth out price volatility and observe overarching price movements across various timeframes.

The authors delve into strategies for capitalizing on short-term, medium-term, and longer-term trends using moving averages like the 5-day EMA, 50-day SMA, and the crucial 200-day SMA to generate buy/sell signals. They also provide tips for developing crossover-based trading systems and incorporating additional indicators like RSI and MACD to improve entry/exit timing.

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Here's how Burns and Burns utilize the 10-day EMA:

• Trend Identification and Confirmation: Consistently trading above the 10-day exponential moving average suggests a bullish trend, giving traders a 'green light' for long positions. On the other hand, when trading is below the 10-day EMA, that indicates a bearish trend, signaling a 'red light' for longs and a potential opportunity to enter shorts.

• Intraday Trading: Day traders often reference the 10-day EMA on intraday charts (e.g., 5-minute or 15-minute) as a dynamic support and resistance level, seeking to buy dips towards the EMA during upward trends and sell rallies towards it during downward trends.

The Ten-Day Exponential Moving Average Works in Trends, Less So in Unpredictable Ranges

Similar to the 5-day EMA, Burns and Burns caution that the 10-day exponential moving average is most effective when the market exhibits a clear trend. During periods of consolidation or range-bound price action, the 10-day EMA might lose its effectiveness, generating false signals and frustrating even seasoned traders.

To enhance the 10-day EMA's effectiveness, the authors suggest:

• Confirming Signals: Look for confluence from additional metrics (e.g., MACD crossovers, RSI readings) before acting on a 10-day EMA signal. For example, if the 10-day EMA surpasses the 50-day SMA while the MACD generates a bullish crossover, it strengthens the bullish case.

• Higher Time Frame Analysis: Analyze the movement on a higher timeframe chart (e.g., daily chart if using a 15-minute chart) to ensure your trades align with the dominant market direction.

• Volatility Filters: Avoid relying solely on the 10-day EMA during periods of high volatility (indicated by tools such as the VIX), as the increased price swings can lead to unreliable signals.

Practical Tips

• Develop a simple rule-based trading strategy that combines the 10-day EMA with other indicators, such as volume or a longer-term moving average, to filter out potential false signals. For example, you might decide to only consider the signals from the 10-day EMA when they are confirmed by an increase in trading volume or when the price is also above a 50-day moving average. Backtest this strategy using historical data to see if it improves the accuracy of your trade entries and exits during consolidation phases.
• Set up a 'trend alignment' buddy system with a friend who is also interested in trading. Agree to check in with each other weekly to discuss the dominant market trends you've observed. This accountability partnership can help reinforce the habit of analyzing higher timeframes and ensure that both of you are considering the broader market direction in your trading decisions.
• Create a volatility-adjusted trading plan by setting up different strategies for different levels of market volatility. You can measure volatility using tools like the Average True Range (ATR) or the VIX index. When volatility is high, you might switch to a strategy that involves shorter trading periods, tighter stop losses, or diversifying across non-correlated assets to reduce risk. For instance, if the VIX is rising, indicating increased fear in the market, you might reduce position sizes or trade less frequently.

21-Day EMA Signals Medium-Range Movement and Offers Support

Moving to a slightly longer duration, Burns and Burns introduce the 21-day EMA. This MA serves as a robust indicator of the medium-term trend, offering valuable insights into potential support and resistance zones.

Here's how the authors utilize the 21-day exponential moving average for trading:

• Intermediate Trend Identification: The 21-period EMA provides a clearer picture of the dominant trend during a medium-term timeframe. If the price consistently closes higher than the 21-day EMA, this suggests strength and a potential uptrend. Conversely, consistently closing below signals weakness and a possible downtrend.

• Trailing Stop Loss: Like the 5-day and 10-day exponential moving averages, the 21-day EMA acts as a wider trailing stop loss, allowing more room for the price to fluctuate while still protecting profits. This is particularly useful in trending yet somewhat volatile markets.

21-day EMA: Last Support in Volatile Uptrend Before Deeper Pullback

Burns and Burns observe that in volatile uptrends, the exponential moving average over a 21-day period may act as a critical support level. If the price breaks below this EMA after a sustained uptrend, it can signal a possible shift in the trend and a deeper correction. Therefore, traders often watch this level closely, particularly after extended rallies.

The authors emphasize the importance of combining the 21-day EMA with other indicators and price action analysis. Examining candlestick patterns, volume, and support/resistance levels around the 21-day EMA can provide additional insights into the strength of the trend and potential trading decisions.

Other Perspectives

• The depth of a correction after breaking the 21-day EMA is unpredictable and may not necessarily be deep; other support levels could prevent a significant pullback.
• The effectiveness of combining the 21-day EMA with other indicators can vary greatly among different asset classes, and what works for equities might not work for commodities or currencies.
• Support and resistance levels are often areas of interest, but they do not guarantee that the price will react in a predictable manner, as false breakouts or breakdowns can occur.

50-day SMA Supports Uptrends, Resists Downtrends

The authors highlight the 50-day SMA as a widely watched moving average, often serving as a dividing line between bullish and bearish sentiment. Its longer duration compared to the previously discussed MAs makes it suitable for identifying more significant trend changes and possible support/resistance areas.

Here's how Burns and Burns utilize the 50-day simple moving average for identifying trends and possible entries:

• Trend Confirmation: The 50-day SMA is a key indicator for confirming established trends. When the price stays consistently over the 50-day SMA, it reinforces an existing uptrend. Conversely, trading below suggests a prevailing downtrend.

• "Buy the Dip" Opportunity: In a robust upward trend, when the price pulls back toward the 50-day simple moving average, it often presents an attractive "buy the dip" opportunity for traders looking to join the uptrend. However, the authors caution against blindly buying any dip. It's essential to look for confirming positive signals, such as a bullish candlestick pattern or positive divergence in other indicators.

50-day SMA: Common Bull Market "Buy the Dip" Support

Burns and Burns explain that the 50-day SMA is particularly important in bull markets, frequently acting as a strong support level during pullbacks. As the market advances and enthusiasm builds, pullbacks to the 50-day simple moving average are often seen as healthy corrections, providing an entry point for investors who missed the initial move.

However, the authors warn that even in bull markets, blindly buying every dip to the 50-day simple moving average can be dangerous. It's vital to analyze price action, volume, and other technical signals to confirm the strength of the underlying trend before entering a trade.

Practical Tips

• Create a paper trading account to practice the strategy without financial risk. Use virtual money to 'buy' stocks when they hit the 50-day SMA after a rally. This way, you can track the performance over time and get a feel for how this strategy might work in real-world conditions without the pressure of actual capital at stake.
• Develop a personalized investment checklist that includes factors beyond the 50-day SMA, such as company fundamentals, market sentiment, and recent news. By creating a checklist, you ensure that you're considering multiple aspects of an investment before making a decision. For example, before buying the dip, you might check the company's earnings reports, any recent changes in management, and overall market trends to get a more comprehensive view of the stock's potential.

100-day SMA Acts As Support Between 50-day and 200-day SMAs, Offering Good Long Entry Opportunities in Oversold Conditions

Burns and Burns describe the 100-day simple moving average as an intermediate-term support level that often comes into play when the price experiences a deeper pullback. This MA lies between the 50-day and 200-day SMAs, signifying a more significant retracement within the broader market trend.

Here's how they use the 100-day simple average in trading:

• Support During Pullbacks: In rising environments, the 100-day simple moving average can serve as a floor throughout corrections. If the price pulls back to this MA and bounces, it suggests underlying buying pressure and that the uptrend may continue.

• Long Entries in Oversold Conditions: The authors highlight that long entries around the 100-day SMA become particularly compelling when combined with oversold conditions in other indicators, such as the RSI. This confluence of signals can suggest a setup that's more likely to result in a rebound.

100-day SMA: Last Support Before Market Reaches Critical 200-day SMA

Burns and Burns warn that if the 100-day SMA fails to hold as support, the price may continue lower, targeting the crucial 200-day SMA. This breakdown beneath the 100-day simple moving average may signal a possible trend change from bullish to bearish, warranting increased caution from traders.

The authors recommend a cautious approach when the price approaches or breaks beneath the 100-day simple moving average. Tightening stops or taking profits in existing long trades might be prudent. Conversely, traders seeking short setups should look for confirmations from other indicators, such as a bearish MACD crossover, before executing a trade.

Other Perspectives

• The concept of a "crucial" 200-day SMA is subjective and may vary among traders and analysts; some may place more importance on other indicators or timeframes for their analysis.
• Market psychology and external events can have a significant impact on price movements, which may override technical signals such as the 100-day SMA.
• If the market has a strong momentum or there is positive news that could affect the asset's price, tightening stops or taking profits might not be the optimal decision, as it could limit the potential upside.
• Over-reliance on any single indicator, including MACD, can lead to an incomplete analysis; it may be beneficial to use a combination of tools to assess market conditions comprehensively.

The 200-Day Average Distinguishes Bull and Bear Markets

Burns and Burns emphasize that the simple moving average over 200 days holds significant weight in the minds of many market participants, often serving as the dividing line between bull and bear markets. Its prominence stems from its representation of the broader trajectory and the psychological impact it has on investors.

Here's why the authors believe the 200-day simple moving average holds importance:

• Bull vs. Bear Market Filter: Burns and Burns suggest that a market consistently trading above its 200-day SMA is considered to be bullish. Conversely, a market consistently beneath this SMA is deemed bearish. This simple filter can help traders determine the dominant market direction and adjust their strategy accordingly.

• Major Support/Resistance: The simple moving average of 200 days tends to act as strong support during bullish trends and significant resistance during bearish trends.

Losing 200-Day SMA May Signal Correction or Downturn; Traders Use as Long/Short Filter

Burns and Burns offer a serious caution: "Falling below the 200-day indicates the initial signal of a potential correction, downward movement, or bear market." They emphasize that a break and a finish beneath the 200-day simple moving average can signal a significant shift in long-term sentiment, often prompting investors to reduce risk and exit long positions.

Traders frequently rely on the 200-day SMA to filter long and short positions. Certain traders adopt a straightforward approach:

• Buy signals are generated when the price exceeds the 200-day simple moving average, confirming a new uptrend.

• Sell signals (or short entry signals) occur when prices fall below, suggesting a new downtrend.

However, Burns and Burns advise against blindly following any single indicator, including the 200-day simple moving average. Always consider confirming signals from additional metrics and the overall market context before you decide how to trade.

Context

• Exiting long positions when the price falls below the 200-day SMA is a risk management strategy. It helps investors protect their capital from potential losses in a declining market by moving to cash or other safer assets.
• The Simple Moving Average (SMA) is a calculation that takes the average of a selected range of prices, usually closing prices, over a specified number of days. The 200-day SMA is a long-term trend indicator used to smooth out price data by creating a constantly updated average price.
• To confirm buy signals, traders often use additional indicators like the Relative Strength Index (RSI) or Moving Average Convergence Divergence (MACD) to assess momentum and avoid false signals.
• Relying solely on one indicator can lead to false signals, where the indicator suggests a trend change that does not materialize, potentially leading to premature or incorrect trading decisions.
• Political events, such as elections, trade agreements, or conflicts, can impact market conditions and should be factored into trading strategies.

Developing Trading Systems With Moving Averages

Spot Patterns With Moving Average Crossovers

Burns and Burns introduce crossovers of averages of price movement as a powerful approach to trend trading, removing subjectivity and allowing traders to base decisions on quantifiable signals. These systems typically involve two moving averages of different lengths (e.g., a 10-day EMA and a 30-day EMA), generating buy and sell signals based on their crossovers.

The authors explain the basic concept of a cross method:

1. Buy Signal: A buy signal is triggered when the faster moving average (e.g., 10-day EMA) crosses above the slower moving average (e.g., 30-day EMA). This suggests that the shorter-term momentum is shifting in favor of the bulls, potentially marking the beginning of an upward trend.

2. Sell triggers: A sell signal is generated when the faster MA crosses below the slower MA, indicating that short-term energy is waning and a downtrend might be underway.

Crossover Systems Outperform Single Moving Averages by Offering Trend Confirmation and Reducing Misleading Signals

Burns and Burns argue that crossover systems based on moving averages offer several advantages over using a lone moving average.

• Trend Confirmation: Crossover systems require confirmation from two averages, reducing the likelihood of prematurely entering a trade based on a false breakout or a temporary price fluctuation.

• Reduced False Signals: The authors find that systems using crossover techniques tend to generate fewer false signals compared to single MA strategies because they filter out some market noise. This can lead to a higher win rate and more efficient trading.

Practical Tips

• Engage in a trading simulation game with friends or family where you can apply crossover strategies in a competitive yet educational environment. Create a game where each participant adopts a different trading strategy, with at least one person using crossover systems and another using single moving average strategies. Over a set period, track who has the most successful trades and the least number of false signals. This friendly competition can provide practical insights into the effectiveness of crossover systems in filtering out market noise.

Improving Crossover Systems With Relative Strength Index and MACD Filters for Better Signals and Maximum Profits

While crossover systems based on moving averages provide a framework for trend trading, Burns and Burns advocate for combining them with other indicators like the RSI and MACD to enhance signal quality and maximize profit potential.

Using RSI to Identify Conditions: Overbought/Oversold for Profits While MACD Confirms Trend

Here's how they integrate the MACD and RSI into their crossover system:

• RSI for Overbought/Oversold: The authors often use the RSI to identify if an asset is overbought or oversold within the context of the crossover signals. For example, if a bullish crossover occurs (e.g., 10-day EMA crossing above 30-day EMA) but the RSI is already above 70 (overbought), they might wait for a pullback and a lower RSI reading before entering the trade to improve the potential reward compared to the risk.

• MACD for Trend Confirmation: The MACD serves as an additional layer of confirmation for the crossover signals.

Practical Tips

• Create a simple spreadsheet to track your favorite stocks using RSI and crossover signals. Start by selecting a few stocks you're interested in and use a free online charting tool to find their current RSI values. Record these values in your spreadsheet daily and note when they cross above or below key thresholds (typically 70 for overbought and 30 for oversold). This will help you visualize the concept and potentially identify buying or selling opportunities.
• Join an online investment community to share and compare your MACD crossover findings with peers. Look for forums or social media groups where amateur investors discuss technical analysis. Share your spreadsheet data and observations on how MACD crossovers correlated with price trends. Engage in discussions to gain insights from others' experiences and refine your understanding of how MACD can be used to confirm trends.

Backtesting and Adjusting Moving Average Crossover Systems Ensures Consistency

Burns and Burns stress the importance of thoroughly backtesting any crossover strategy involving moving averages before implementing it with real capital. Backtesting involves historically examining the system's performance over various market conditions to evaluate its profitability, risk profile, and suitability for a specific trading style.

Traders Must Adhere To Their System's Rules During Losing Streaks, As Abandoning a Successful System Can Harm Long-Term Results

After a system has been backtested and optimized, Burns and Burns emphasize the critical importance of discipline and adherence to the system's rules. This is especially crucial during inevitable losing streaks. Emotional decision-making and deviating from the plan can lead to inconsistent results and underperformance.

Remember, even the best trading systems don't produce profitable trades 100% of the time. Trust the process, manage risk carefully, and allow your system to work its magic over time.

Other Perspectives

• Blindly following a system during losing streaks can lead to significant drawdowns that could be mitigated by adapting the system or temporarily reducing exposure.
• Adherence to a system without periodic review could ignore new information or changes in the market that could be incorporated to improve the system.
• A system's rules may have been based on historical data that does not guarantee future performance, especially in markets that are influenced by unpredictable geopolitical or economic events.
• Emotional decision-making can sometimes capture market sentiment better than rigid systems, as human intuition might sense subtleties that a predefined system cannot.
• Relying solely on a system, even with careful risk management, may overlook the need for human judgment in unforeseen situations.