Using Moving Averages to Improve Your Stock Trading
Look at Trends or Support Levels?
A Stock That’s Building an Early Stage Base
With the market settling down somewhat during the past week, I thought I’d return to my stock chart series with this Wealth Advisory. Today, I touch on something that appears on almost every stock chart you’ll see, but few investors know how to use—moving averages.
So far in this series, I’ve covered how to use volume clues in your chart analysis, as well as how tightness can tell you when a stock has come under control. Remember, the way I use charts isn’t about chart patterns that you’ve probably heard about (pennants, triangles, head and shoulders, etc.)—for me, it’s all about evaluating supply and demand, picking up clues that tell me whether institutional investors (the ones who control well-traded stocks) are generally buying or selling.
The only two things in the world that are going to give you a direct measure of supply and demand are price and volume. That’s it. Everything else that you might see on a chart is derived from those two things.
If I were forced to limit myself to just two things on a chart, it would be price and volume.
Thankfully, I’m not limited to just price and volume, and I make extensive use of moving averages to help clarify a stock’s standing. As a very brief background, simple moving averages take the last X number of closing prices, add them up and divide by X. Thus, a 50-day moving average basically tells you the stock’s (or index’s) average close during the past 50 trading days. Another, more complicated method is to calculate exponential moving averages, which give more weight to recent closes, but I’ve never used them—I like to keep things simple.
As it turns out, the 50-day line is probably the most common moving average; I use it as a demarcation line of sorts between an intermediate-term uptrend and downtrend. On a daily chart, I also use 25-day (shorter-term) and 200-day (longer-term) moving averages. See the chart of Splunk (SPLK) below; the red line is the 25-day, the blue is the 50-day and the green line is the 200-day.
There’s no perfect way to use moving averages to your advantage—heck, there’s nothing special or sacrosanct about the 25-, 50- and 200-day moving averages. But I do have some helpful hints (some basic, some more advanced) that can improve your buying and selling:
1. On the buy side, moving averages (MAs) are an easy way to eliminate those tempting story stocks that really aren’t performing. I have NEVER bought a stock that’s trading below its 200-day moving average, and have rarely bought one below its 50-day line. Simply put, if a stock is below these MAs, it’s not in an uptrend. It’s fine to watch it, but not to plow into it.
2. On the sell side, if a stock has been above its 50-day line for many weeks, and then breaks it decisively (for more than a few hours, on above-average volume, by a meaningful amount, etc.), it’s a sign the intermediate-term uptrend is over. (This is actually the basis of my Cabot Tides market-timing indicator.)
3. As a follow-up to #2, for individual stocks, you can use the same theory with a 25-day moving average at times. In other words, if a stock is super-strong and has been trending above its 25-day line for eight, 10, or 12 weeks in a row, and then it decisively breaks it, you can usually use that as a time to sell (or trim) your position, instead of waiting for the 50-day average to break.
4. On the flip side to #2 and #3, if a stock is base building for many weeks, and then pops back above its 50-day line, you can often buy some (or add a little to your existing position) right there. Crocs (CROX) was a perfect example back in the spring of 2007; we put it on buy in early April and it never looked back from there.
5. I know many investors like to follow moving average crossovers, i.e., when the 50-day line falls below the 200-day line on the chart, it’s a sell—the so-called “Death Cross.” (Insert foreboding music here.) But I’ve never found much value in crossovers, as they tend to lag too much; if MAs themselves are secondary to price and volume, then MA crossovers are secondary to MAs ... and that’s one secondary too many for me.
6. One technique I learned back in the early 2000s is how to use moving averages to avoid getting into a stock too early. Say a stock is base building, then comes to life and quickly moves to new highs. Well, if the 25-day line is still below the 50-day line, it’s usually the case that the breakout attempt won’t work—it’s telling you the stock still needs time to set-up. This doesn’t apply to a huge earnings gap, for instance, but it can help you avoid buying into what turns out to be a failed breakout. Take a look at Amazon.com (AMZN) last September—the move above 310 looked good, but shares needed more time (and one more shakeout) before getting going.
7. As for buying at support on the 25-day or 50-day line, I’m all for it—in fact, institutional investors love to do that because there’s usually a chance to grab a good amount of shares. My only advice is to keep a relatively tight stop in place; if you’re buying at the line, the stock should find support very soon. If it doesn’t, the basis for the trade was wrong, so you should move quickly to cut the loss.
8. Lastly, I know many investors like to use the 50-day MA as a trailing stop of sorts. I’ve heard of worse ideas, but just remember that (a) tons of investors watch the 50-day line, which can lead to some false breakdowns, and (b) MAs in general should be considered fences that can be leaned upon, not hard-and-fast exact levels of support. Thus, the 50-day line is vital, but it’s best used as one selling tool among many.
All in all, I’ve always found moving averages to be helpful with my own chart analysis. They’re not the be-all and end-all, but they can improve your trading by strengthening your buy and sell decisions.
For my stock idea in this Wealth Advisory, I’m going to borrow from point #4 above—finding stocks that are building early-stage bases and could provide entry points on a push back above their 50-day lines. I’m actually seeing quite a few names that are in this category today ... which tells me the next few trading sessions will be a good test for growth stocks in general.
One name I’m watching on that front is Arris Group (ARRS), which, thanks to a fish-swallows-whale purchase of Motorola Home from Google (the purchase more than doubled Arris’ size!), is one of the top dogs in supplying set-top boxes and other equipment that allow cable firms to offer next-generation TV services. Here’s a background write-up I did on the company in Cabot Top Ten Trader back in January:
“Broadband hardware maker Arris Enterprises is poised for a major growth surge in 2014 as demand for its products surge thanks to next-generation TV services. The company’s acquisition of Motorola Mobility’s Home business—which more than tripled the company’s size—has allowed Arris to become the leading video client provider (read that as set-top boxes), with more than 500 customers in 70 countries. Since the acquisition, Arris’ revenue has spiked from roughly $350 million in the first quarter of 2013 to more than $1 billion in each of the past two quarters! The company’s most recent coup is a deal with Comcast, the largest cable TV operator in the U.S. Specifically, Comcast is launching Arris’ XG1 gateway for its next-gen TV service. Furthermore, Comcast is deploying Arris’ E6000 Converged Edged Router to enable its converged cable access platform. Looking ahead to 2014, analysts are projecting sales growth of 31% for Arris, with a nationwide push toward IP TV seen providing a significant boost to the company’s bottom line.”
Not much has happened news-wise since then—Arris did report a solid fourth quarter (sales up 249% because of the acquisition, earnings up 93%), and analysts continue to expect solid earnings growth this year (up 26%) and next (up 20%). If you’re wondering, the current P/E is just 16, so it’s still being discovered.
Moreover, the stock just got going from a multi-year consolidation in November of last year. After running from 18 to 31, shares are now in their ninth week of base building, and are approaching their 50-day (blue) line, which is now around 28.
Overall, the market is still questionable, and ARRS is reporting earnings soon (May 6), so I am certainly not pounding the table. But if you’re game, you could consider a small position if ARRS rips above its 50-day line in the days ahead (big volume, decisive move), with a tight stop near 26.
To learn more about 10 additional momentum stocks featured in this week’s Cabot Top Ten Trader risk-free, click here.
All the best,
Chief Analyst of Cabot Top Ten Trader
and Cabot Market Letter