Prior to moving into trading full time I spent a number of years with a leading global home improvement company. One thing I learned in that culture is that a tool that serves multiple purposes is worth its weight in gold. Multipurpose tools are economical, time efficient, and allow you to accomplish much more than you planned due to its versatility.
In trading terms, one of the best multipurpose tools is the moving average – the average price data of a stock or ETF over a specific time period.
As I showed you recently, you can use a stock’s Simple Moving Average (SMA) to determine its direction. If the moving average line is on an incline going up from left to right, it tells you the stock is in an uptrend. If it slopes down from left to right, it tells you the stock is in a downtrend.
But this versatile technical trading indicator is like a Swiss Army knife for traders… and it is one of the go-to technical indicators in my trader’s tool chest.
Let me show you what else it can do…
Finding Support and Resistance
As you’ve seen, the Simple Moving Average, (SMA) is a great way to discover a stock’s trend – where it’s price has been and where it’s going.
But as I mentioned, you can also use a moving average to determine a given stock’s support and resistance levels.
Support is the price or range at which a stock supported from trading any lower in price. Downtrends in price tend to slow as a stock approaches support thanks to a concentration of demand – a number of traders willing to buy at that level.
Resistance is the price or range at which a stock resists going any higher in price. Uptrends in price tend to lose steam at resistance thanks to a concentration of supply – a surge of traders willing to sell at that level.
For a bullish trade, you want to buy the stock or call options at a support price, and sell when it trades to a resistance price.
The premise of trading support to enter a position is that buyers will come in at that support price and buy up the stock for any number of reasons; they believe it is fairly priced at that number, or perhaps the stock bounced up in price off that support level multiple times.
Here is an example of the 200-day SMA serving multiple purposes for me on the chart for Nike Inc. (NYSE:NKE). Take a look:
This chart tells me two things:
- NKE is in an uptrend; and
- The 200-day SMA is the price that ended up being support for a stock. NKE was supported from going any lower than the 200-day and went higher after trading at it for a day.
You can see that technical analysis isn’t so much a science, but a bit of an art as the price did trade under the 200-day SMA during the day versus trading on it right to the penny. If you’re trading on support/resistance, you can set your stop order trigger if the stock closes below the 200-day SMA – a good indicator that it’s time to cut your losses.
Now, there isn’t one universal moving average for every underlying. Different stocks will react differently to different moving averages – you’ll see a different picture if you use the 50-day SMA as opposed to the 200-day SMA. Your job as a technical trader is to look at different moving averages, see how a stock reacts, and figure out how to trade accordingly.
Case in point, take a look at the chart for Apple Inc. (NASDAQ:AAPL) and you will see that the 50-day SMA is the current simple moving average that is acting like resistance; AAPL hit that 50-day SMA and resisted going any higher for right now, and in fact rolled over in price a bit.
If you were already in on a long call option trade on AAPL, you could consider this moving average as the resistance point at which you would want to sell your calls. If it breaks through to the upside and retests as new support, you can always consider a new trade on it, but for now it may be best to deem this resistance point as the best place to close the trade.
If you had no current option trade on AAPL, this could be the place to initiate a long put trade. You would look for AAPL to trade lower from resistance and for your puts to increase in value when the stock goes down in price. In that case, you’d set your stop to trigger if the stock closes above resistance.
Discover the Best Entry (and Exit) Points
Knowing support and resistance gives you the opportunity to pick the best entry price for a new options trade, or it can tell you when to get out of an existing one.
But did you know that you can use more than one SMA on your charts? The most commonly used moving average among investors is the 200-day. To calculate the simple moving average, you add up the closing price over the last 200 trading days and divide that total by 200.
If you trade options, however, you’ll want to use a shorter timeframe to judge your trades, since your trades will take less time to develop.
You can combine moving averages to look for trading signals to enter or exit an options trade, or to determine whether you should make a bullish or bearish move. For example, let’s say you plot the 50-day SMA and the 200-day SMA on stock chart. When the 50-day crosses up through the 200-day SMA, that’s a bullish signal. But when the 50-day crosses below the 200-day, that’s a bearish signal.
One strategy I use for options trading that incorporates the 10- and 30-day moving averages and their crossovers for entry and exit points in option trades.
I favor technical indicators that have more functionality; they provide me more than just one perspective that helps me determine if I want to take an option trade on a given stock or disregard it because it doesn’t give a clear sign it is time to do so.
The Simple Moving Average is just such an indicator, and a trading tool I would encourage all of you to keep in your trader’s tool chest.
But be careful you don’t let the view on the SMA talk you out of a good setup. Rather, it’s best to use a good chart with a strong SMA to support an already favorable setup. In other words, it’s fine to use the SMA to add confirmation to a trade consideration, but don’t let it talk you out of a possibly profitable trade.
Here’s your trading lesson summary:
The Simple Moving Average (SMA) isn’t just a good tool for determining trend. Here’s what else it can do…
- The SMA can show you support/resistance levels.
- Different SMAs can tell you different things about how a stock’s price is behaving.
- SMAs can be a good way to determine entry/exit points on your trades.