Before you jump into a new stock with both feet, it's a good idea to check the water first and see how the major indexes look.

The daily back-and-forth can feel like an immense amount of information to process. But with the proper grasp on moving averages, you can understand the market action and learn what the trading environment looks like.

Investors use moving averages to track and identify trends by smoothing the normal day-to-day price fluctuations. Look at the daily chart of the Nasdaq composite on MarketSurge or IBD Charts. That red line is the 50-day moving average. Where the 50-day line runs each day is determined by averaging the closing prices of the previous 50 days.

Because it's calculated using prior data, the 50-day line is inherently a lagging indicator; it alone cannot predict what a stock or index will do. When combined with other tools, what it can do is contextualize the day's action and help you prepare for the days to come.

The 21-day exponential moving average, which gives a higher weighting to the most recent days. This allows for a quicker, more responsive moving average.

Generally, you want to see the Nasdaq and S&P 500 trade above the 50-day line, and even the 21-day line. A drop below the 50-day line should be treated with caution. A sharp and fast break below the line or the 200-day average marks a "vertical violation" that often signals a market correction.

Moving Averages In The 2020 Market



From May to September of 2020, the Nasdaq was trending above both the 21- and 50-day lines. This is what MarketSchool calls a Power Trend. This is the most optimal time to be invested. For these four months, the Nasdaq climbed steadily and never closed below the 21-day line. This tendency to stay above a moving average is called support and helps us to set our expectations.

With an internally developed AI tool, we know that statistically the Nasdaq is more likely to reverse after being 6% or more above the 50-day moving average. The signal triggers 5% or more for the S&P 500. Using the Track Price tool in MarketSmith, click on any day in a chart to view the moving average values on that day and how far above or below the index was.

Though the Nasdaq was routinely 4%-10% above the 50-day average, the support it found with 21-day kept the outlook positive.

On Sept. 3 time was up (1). The Nasdaq fell nearly 5%, closing near lows but above the 21-day line. This was your last chance to take profits before it fell another 5% the next day, bouncing off the support of the 50-day but failing to clear the 21-day. What was once an area of support turned into resistance.

This article was originally published Jan. 21, 2022 and has been updated.

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