Do Moving Average Crossovers Show Momentum?

Key Concepts

• Moving Averages: A lagging indicator used in technical analysis to smooth out price data and identify trends. The calculation involves averaging prices over a specific period.
• Momentum: The rate of acceleration of a security’s price. Traders often seek to identify changes in momentum to predict future price movements.
• Lagging Indicator: An indicator that confirms price trends after they have already begun, rather than predicting them.
• Illusions in Technical Analysis: Misinterpretations of chart patterns or indicators that lead to incorrect trading decisions.
• Mathematical Basis of Indicators: Understanding that technical indicators are derived from mathematical formulas and are not inherently predictive.

Moving Average Crossovers and Momentum: A Detailed Analysis

This session of “Coach’s Corner” at Market Rebellion addresses a common misconception among traders: the belief that a stock crossing a moving average signifies a change in momentum. Bill Johnson and Stu discuss why this interpretation is often an illusion, rooted in the mathematics of moving averages rather than a genuine predictive signal.

The Common Misconception

Many traders interpret a stock price crossing a moving average – either from below upwards or from above downwards – as a definitive indication of a shift in momentum. The logic is that if a stock consistently stays above a moving average after crossing upwards, or below after crossing downwards, this confirms the change in direction. This belief is prevalent in technical analysis and often forms the basis for trading decisions. As Bill Johnson notes, “It’s a story that fits the picture, and unfortunately is not quite right.”

The Core Argument: Math, Not Momentum

The central argument presented is that moving average crossovers do not inherently indicate a change in momentum. The perceived confirmation of momentum is a consequence of the mathematical properties of moving averages, specifically their lagging nature. The presenters emphasize that the crossover itself is not a predictive event, but rather a result of the averaging process.

Illustrative Example: The Five-Day Moving Average

To demonstrate this, Bill Johnson uses a simplified example with a five-day moving average and a series of fabricated price points (5, 10, 15, 20, 25, 20, 15, 10, 5, and then back up). He meticulously calculates the moving average at each point, showing how the average inherently “catches up” to price changes.

• Lagging Effect: The moving average is calculated using past prices. Therefore, it will always lag behind current price movements. When a price crosses the moving average, the average is still influenced by previous prices, creating the illusion of sustained momentum.
• Mathematical Necessity: The presenters explain that the behavior of the moving average after a crossover is mathematically determined. If prices cross from below, the moving average must stay above for a period because it’s still incorporating the higher previous values. Conversely, crossing from above necessitates the average staying below.
• Scaling Independence: The presenters clarify that the length of the moving average (5-day, 20-day, 50-day, etc.) doesn’t change the underlying mathematical principle. The effect is consistent regardless of the time frame.

Real-World Application: Apple Chart Example

A chart of Apple (AAPL) is used to illustrate the phenomenon in a real-world context. The presenters point out numerous crossovers and highlight how traders might incorrectly interpret these as signals of changing momentum. They emphasize that the chart itself is a “story being depicted” of price action, not a predictor of future movements.

The Illusion of Confirmation

The presenters highlight that traders often seek confirmation bias, interpreting crossovers as validation of their existing beliefs. They state, “It’s a story that fits the picture,” and caution against relying solely on these signals for trading decisions.

Risk Management and Trading Strategy

Stu emphasizes that if moving averages are used, they should be integrated into a broader risk management strategy, not relied upon as standalone signals. He suggests that the question shouldn’t be “When should I get out based on a crossover?” but rather “What is my overall trading thesis, and when does that thesis no longer hold true?”

Notable Quotes

• Bill Johnson: “It’s a story that fits the picture, and unfortunately is not quite right.”
• Stu: “It’ll continue until it doesn’t.”
• Bill Johnson: “There’s nothing magical about any of it once you understand the math of how it works.”

Technical Terms Explained

• Candlesticks: A type of financial chart that displays the high, low, open, and closing prices of a security for a specific period.
• Delta (Options): A measure of an option's price sensitivity to changes in the underlying asset's price. (Mentioned in the context of rolling options).
• MACD (Moving Average Convergence Divergence): A momentum indicator that shows the relationship between two moving averages of prices.
• RSI (Relative Strength Index): A momentum oscillator that measures the magnitude of recent price changes to evaluate overbought or oversold conditions.

Logical Connections

The discussion flows logically from identifying a common trading misconception to dissecting the underlying mathematical principles. The use of a simplified example with fabricated data reinforces the core argument before applying it to a real-world chart. The conversation then transitions to practical implications for risk management and trading strategy.

Data and Research Findings

While no specific research findings are cited, the presentation is based on decades of real trading experience at Market Rebellion and a deep understanding of technical analysis. The demonstration with the five-day moving average serves as a micro-level “experiment” to illustrate the mathematical principles at play.

Synthesis/Conclusion

The key takeaway is that moving average crossovers are not reliable indicators of momentum. They are a natural consequence of the lagging nature of moving averages and should not be interpreted as predictive signals. Traders should understand the mathematical basis of these indicators and integrate them into a comprehensive risk management strategy, rather than relying on them as standalone trading signals. The session encourages a more critical and informed approach to technical analysis, emphasizing the importance of questioning assumptions and avoiding the pitfalls of confirmation bias. The overarching theme, as highlighted by Bill Johnson, is to “hit the brakes” and critically evaluate the information presented by charts and indicators.