After trading above its 50-day moving average for 130 trading days, the S&P 500 finally succumbed to the recent selling pressure and broke below this pivotal line in the sand during last Thursday’s bloodbath. Is this a minor bump in the road or a harbinger of doom for stock prices? Only time will tell. Understanding why options trading investors and other market participants place so much emphasis on this simple little line first requires an elementary understanding of moving averages.
Of the myriad of technical indicators available, moving averages have risen as not only one of the most popular, but also one of the most effective. Perhaps the popularity is due in part to their simple yet versatile nature. Traders can use them for anything from identifying trends and reversals to measuring momentum and crossovers. Moving averages are trend following in nature making them a particularly potent indicator during strong trending markets. In choppy environments they lose much of their mojo and can become downright useless. Though they can be measured on any time
frame, the 50-day moving average has become a staple for most chartists. Indeed, it is usually displayed by default on most charting platforms and is often used to aid in identifying the intermediate trend of the market.
When it comes to trend reversals, the 50-day moving average has provided particularly timely signals in the S&P 500 Index over the past few years. When prices break above or below this moving average, many traders consider it a sign that the intermediate trend is reversing. To avoid too many false signals some wait for prices to break the moving average by 1% or more to confirm it’s a bona fide break. Consider the chart below highlighting the most recent signals (green for buy, red for sell). While the signals are far from infallible they do have a good track record of keeping traders on the right side of multi-month trends.
Whether or not the current signal proves as fruitful as the last few signals remains to be seen. Also, we have yet to break the 50-day moving average by 1% leaving some to contend that we need more confirmation before passing judgment. At the least, the resolution of the current testing of the 50-day moving average will be something many traders monitor with increasing interest.
Follow Tyler Craig on Twitter@TylersTrading.