The Psychology of The Moving Averages

By now, you have heard us write extensively about the type of analysis called "Technical Analysis." 

The definition from Investopedia of this word says… 

"Technical analysis is a trading discipline employed to evaluate investments and identify trading opportunities by analyzing statistical trends from trading activity, such as price movement and volume." 

That is a mouthful! 

We will say it differently: technical analysis uses patterns in the stock price data to predict what is LIKELY to happen next. 

The basic idea is to use the price history to help us predict the next move. 

Now, these predictions are not about being right 100% of the time but about knowing the higher probability of moving. 

The same way it would be in blackjack when you play the right hand… 

In our HX Podcast, we discussed this concept with renowned technician J.C. Parets. You can listen here. 

One of the most referenced technical analysis indicators is the "moving average."    

The moving average is a simple calculation. For the "50-day" moving average, you would take the last fifty days of closing prices, add them together, and divide by 50, thus getting the average. 

The most used moving averages are the 50-day, 100-day, and 200-day. 

Here is a chart of Bitcoin with the moving averages on the chart… 

The 50-day is pink, the 100-day is green, and the 200-day is yellow. 

What do these moving averages tell us? 

The theory is that the moving average can act as "support" and "resistance." 

"Support" is said when the asset trades down to the level of the moving average. The idea is that once it does that, it will be harder for it to continue trading lower. 

"Resistance" is said when an asset trades up to the level of the moving average. The idea is that it will be harder for it to trade higher through the moving average. 

Why would this make any sense? Isn’t it all voodoo looking at lines on a chart? 

The answer is that IT DOES make sense.   

The way to explain it is through a "cohort analysis." This is a wonky MBA term that has become quite popular, but the easy way to understand it is that it is an analysis that looks at the participants in a group broken up by some measure. 

We like to think of the TIME cohorts for stocks and technical analysis. This means when someone bought the stock and at what price. 

This is what the moving averages tell us. 

For instance, when you look at the 50-day moving average by definition, you can imagine that a great deal of people ON AVERAGE own it around that price. Again, it is literally the definition. 

Go back to the Bitcoin chart above. The 50-day moving average is currently at $54,740, and the 100-day moving average is at $48,883. 

This tells us that many investors likely own bitcoin around these levels. For the sake of this analysis, let's call it $50,000. 

On average, if someone bought or sold bitcoin in the last 100 days, it was bought around the $50,000 level. 

This is why this level might act as support. 

Here is why… 

Let's say you bought Bitcoin at $50,000 and then sold it at $65,000. Now that it is trading back down to $50,000, you are likely inclined to buy it again! 

After all, you JUST bought it at that level and made a nice profit. Why not do it again? 

We don't know how many people sold Bitcoin above $50,000, but we know a lot of them bought it around that price. Again, the average tells us that. 

Here is another scenario: You bought at $50,000 and didn't sell. You think Bitcoin is going higher, or you didn't want to sell for whatever reason. 

You are even less likely to sell 

 once it returns to $50,000 initially! 

After all, you own it at that level and just showed a nice paper profit. Also, if you sell it below $50,000, you book a loss right after making a profit. No one wants to do that! 

This is why there is some level of “support” at these moving averages. 

Now, this "support" doesn't mean that the asset will not reach these levels. If the number of enthusiastic sellers willing to sell at lower prices is greater than the number of folks in the two situations we talked about above, then it will go lower. 

We just know that a bunch of folks have (or had) a $50,000 cost basis. At that point, they will be psychologically compelled to either buy or not sell. 

Do you use moving averages in your trading? Tell us more in the comments section online (scroll to the bottom of the post).

This is the psychology of how moving averages can tell us something about the probability of what might happen next with an asset. 

Understanding technical analysis cannot predict the future, but it can help you figure out how to hedge your bets… 

Check out Enrique Abeyta’s conversation with JC Parets on the HX Podcast.