There's nothing magic about moving averages. If no one could look at a chart of a stock, and if no one could calculate moving averages, stocks wouldn't bounce off of moving averages. But because people expect certain stocks to find support at the moving averages, they buy at the moving averages. That's a self-fulfilling act. Moving averages, support and resistance areas are not based on calculations like momentum, MACD, RSI, etc. They are simple, visual phenomena that are quite straightforward and easily understandable. If a stock is experiencing a minor correction, not related to fundamental issues, but merely a declining price momentum or overbought condition, it will likely find support at a series of moving averages. In my experience, such a stock will rarely fall below its 200-day MA, unless expectations about the fundamental outlook are changed.
I find that there are 4 commonly used simple MAs: 25-day, 50-day, 100-day and 200-day. If a stock has a lot of momentum, and it's riding above its 25-day MA, any loss of momentum will see the stock bounce off of the 25-day MA. But that's only because traders know where this MA lies. Accordingly, they buy when the stock approaches the average. Often, one can notice an increase in volume as a stock nears a major MA.
If the stock evenutally returns to the 25-day MA, many traders will wait until it hits the 50-day MA, perhaps because they have already bought more stock at the 25-day MA (a higher price). The stock will generally bounce off of the 50-day MA, but only because traders are waiting to buy it there. When the stock is above the 50-day MA, but below the 25-day MA, it will attempt to break out above the 25-day MA, after it bounces off of the 50-day MA. Sometimes, traders will sell the stock at the 25-day MA, so they can cut their losses, and because they expect it to face resistance (because there's a lot of selling at that point). The stock may then fall back and break the 50-day MA, as traders wait for more buying support at a lower price. Each previous support line becomes a resistance line if the price moves from above the MA to below the MA. Vice versa, too. This whole phenomenon may continue until the stock reaches the 200-day MA, at which point it should find solid support. One self-fulfilling reason that 200-day MA provides better support than 25-day and 50-day MA is that it's considered to be more important. Accordingly, the traders believe that there will be support at that level, and they place their buy orders.
Let's recap:
1. Stock above 25-day MA.
2. Stock falls to 25-day MA and bounces, perhaps to the previous high.
3. Stock falls back to 25-day MA and breaks through.
4. Stock falls to 50-day MA and bounces.
5. Stock FAILS to penetrate the 25-day MA from below.
6. Stock falls back to 50-day MA and breaks through, because the stock showed technical weakness by failing to recover above the 25-day MA. To some traders, this confirms a SELL signal.
For each technical breakdown, however minor, the stock appears weaker than before. As a result, selling pressure increases. In step 2 (above), the stock finds support, BUT forms a short-term double-top. In step 3, it breaks a support level (double-top and broken support). In step 4, it finds support, but in step 5, it meets resistance (double-top, broken support, failed to break resistance). In step 6, the stock breaks a more important support trendline, falling to its 100-day MA (it wouldn't fall to its 85-day MA, because no one graphs this MA. The stock will react to the most commonly used MAs. That's another reason that the 200-day MA is the most supportive.). Sometimes, a stock will fall through more than one MA before finding support.
So by the time the stock is falling to its 100-day MA, it's been very weak, technically. It has lost momentum, formed a double-top, broken support (25-day), failed to break resistance (25-day), broken more support (50-day). If the 100-day MA has been a very good support level in the past, it will likely continue to be good. This is only predictive because traders expect it to be predictive. It is a psychological, not statistical indicator. The stock may bounce between the 100-day and the 50-day, until it penetrates one of the MAs.
For reference (and evidence), check out this chart of SMTC:
chart2.bigcharts.com:80/chart?time=8&freq=1&uf=0&lf=1&type=2&style=1&size=2&comp=&state=0&trans=0&symb=smtc&r=chart&compidx=aaaaa%3A0&ma=3&maval=25&sid=4401&sec=c&xyz=65338531&s=25254
For this chart, SMTC had been supported for a while by its 25-day MA. When it finally broke this trendline, it fell through the 50-day MA, without finding any support from it. And in December, the 50-day MA because resistance.
chart2.bigcharts.com:80/chart?time=8&freq=1&uf=0&lf=1&type=2&style=1&size=2&comp=&state=0&trans=0&symb=smtc&r=chart&compidx=aaaaa%3A0&ma=3&maval=50&sid=4401&sec=c&xyz=65592594&s=24049
In this second chart, SMTC fell all the way to the 100-day MA, where it found support and bounced back to the 50-day MA, where it met resistance. It then broke through the support at the 100-day MA. Notice how the 100-day MA and the 50-day MA are resistance levels in December.
chart2.bigcharts.com:80/chart?time=8&freq=1&uf=0&lf=1&type=2&style=1&size=2&comp=&state=0&trans=0&symb=smtc&r=chart&compidx=aaaaa%3A0&ma=3&maval=100&sid=4401&sec=c&xyz=65868328&s=21212
In this third chart, see how SMTC fell through the 100-day MA and bounced sharply off its 200-day MA. It then met resistance at the 100-day MA. Also note the attempt at a head-and-shoulders reversal pattern. The head was formed at $20 (200-day MA), the shoulders are at $23.50, and the neckline is at $27.50. It almost worked, but the 100-day MA killed the reversal attempt in the 2nd week in December, causing the stock to fall back to and through its 200-day MA. Notice how the stock very recently met resistance at its 200-day MA, and failed to penetrate it.
The stock is currently being supported by the very tenuous 10-day MA, and the 25-day MA, as it attempts to break through its 200-day MA: chart1.bigcharts.com:80/chart?time=7&freq=1&uf=0&lf=1&type=2&style=1&size=2&comp=&state=0&trans=0&symb=smtc&r=chart&compidx=aaaaa%3A0&ma=1&maval=10&sid=4401&sec=c&xyz=66480625&s=16481 Today, SMTC met resistance at $23, where it previously failed to penetrate its 200-day MA. You want predictive value? We'll see, but it looks as if SMTC will breakout above $23 (and its 50-day and 200-day MA) later this week. If it does, it becomes a trading BUY, because of its technical strength. The next resistance level is $27. It's not necessary to understand Fibonacci numbers and MACD to successfully trade stocks. It doesn't always apply to every stock, but the principle is the same.
Class dismissed. ;-}
Todd |
