Before most folks even learn the difference between a stock and a bond, they hear about "bull" and "bear" markets.

 

A bull market is a period of rising prices. A bear market is a period of falling prices.

 

But how can we make a claim that an asset is in a bull market... a bear market... or somewhere in between?

 

This is where the concept of the moving average is useful.

 

The "moving average" collects a bundle of an asset's closing prices – say, each one from the past 200 days – then takes the average of those prices.

 

This produces a chart line that "smoothes" out market volatility so we can gauge the big-picture trend. When a market is trading above its moving average, it's in a bull trend. When a market is trading below its moving average, it's in a bear trend.

 

You can do the same thing with a 50-day moving average, a 20-day moving average, pretty much any timeframe you want. But the most widely used moving average on Wall Street is the 200-day moving average, a good middle-of-the-road indicator that averages the prices from about 10 months of trading.

 

Let me show you how it works with an example. Below, you'll find a five-year chart of crude oil...

 

 

In early 2007, the price of crude oil moved out of a sideways trading pattern and crossed above its 200-day moving average (A). It continued this price strength and climbed toward a huge top at $145 per barrel.

 

In mid-2008, oil had come down off its top and crossed below its 200-day moving average (B) on the way to a crushing $35 per barrel bottom.

 

Months later, oil moved higher yet again, crossing above its 200-day moving average in early 2009 (C) and signaling a new bull market.

 

Except for some "whipsaws" (D) this summer, where the trend was unclear, the 200-day moving average served as "guidepost" for gauging the big-picture trend in oil.

 

If you wanted to take the easy way out, all you had to do was buy oil when it crossed above its 200-day moving average and sell it when it fell back below. Though oil is only up 40% since early 2007, you would have made nearly 150%.

 

For the majority of traders, however, moving averages won't solely dictate buy and sell decisions. But they can serve as handy guideposts when you're studying trends.

 

Good trading,

 

Brian Hunt