The Moving Average is one of the most commonly used technical indicators.
In fast moving markets you may find that the price may be surging up, only to plummet moments later before surging up again increasing the potential for false signals.
The Moving Average can help filter out the noise from random price movements and smooth it out in order to see the average value.
Moving averages are used to identify trends and confirm reversals.
When the price is above the Moving Average line, we consider the instrument to be in an up trend
Conversely, if the price is below the Moving Average line we consider it to be in a down trend
The breaking of the moving average line usually implies a trend reversal
Moving averages are also used to identify areas of support and resistance.
Many traders will consider the moving average line as a support and resistance level indicator and base trades on it
So traders will check to see whether the price is going towards the moving average and see whether it will bounce back from it or break it as with regular support and resistance levels.
Often times, the price of an instrument will find support at the moving average line when the trend is up and will find resistance at the moving average line when the trend is down
Moving averages will tell you whether the trend is moving up, down or if it’s ranging.
It can tell you if a trend is still in motion and whether it is reversing or losing momentum
Have in mind that moving average is based on past prices and is known as a lagging indicator, therefore it will not warn you in advance but it will confirm when a trend change has taken place.
At the most basic level, when the price crosses up and over the moving average traders take this as a signal to buy. When it crosses down under the moving average line they consider it a signal to sell.
Types of Moving Averages
Simple (SMA)
Weighted
Exponential
Simple Moving Average (SMA)
If you wanted to plot a ten day simple moving average, you would add the closing prices of the last ten days and divide the sum by ten.
This calculation gives equal weight to each day.
It’s called a Moving Average as the oldest price is dropped each time a new period becomes available, in this way ensuring that the average is based only on the last x number of periods, i.e. for the last ten days in our example.
Have in mind that the longer the Simple Moving Average period, the more it lags and the slower it is to react to the most recent price movement.
Downside: As equal weight is given to all periods considered in the calculation, the Simple Moving Average is slower to respond to rapid price changes that might prove to be important.
So how can you counter this?
With another type of Moving Average: either a weighted or an exponential moving average.
Weighted and Exponential Moving Averages (WMA & EMA)
The weighted and exponential moving averages are calculated differently from one another, but both types give more weight to recent periods and that’s more emphasis on what traders are doing at the moment.
As a result, weighted and exponential moving averages respond faster to price action by distributing more weight to recent periods and less to older periods.
They reflect quicker shift in sentiment, which can be due to changes in supply and demand or important news events that impact the traded instrument.
If you were to plot an exponential moving average and a simple moving average on a chart, you’ll see that the EMA is closer to the current price than the SMA.
Time Periods
Apart from the type of moving average you also have to decide on the time period.
This will largely depend on the type of trend you are analysing.
Commonly used time periods:
10 – 20 for short-term trends
50 for mid-term trends
200 for long-term trends
When & How Should you use MAs
Deciding which moving average to use and the time period will depend largely on your objective.
Use EMA for shorter time frames or if you’re analysing a fast-moving market as you’d have more emphasis on the latest prices.
Use SMA if you’re planning on holding a position for a longer period of time as the EMA might be too sensitive and give false signals.
You should also use SMA if you’d just like to filter out the noise of random price fluctuations to determine the overall market direction.
Identifying Trend Direction
To determine the direction of a trend using MAs you must take into account the set time period.
The difference in the direction of a trend portrait by the moving average is due to the time period.
Shorter period MAs are faster at generating signals and changes in the price of the instrument will be reflected more quickly.
The longer period MA will react to price changes much more slowly, but will generally provide more reliable trading signals.
Entering and Exiting Trades
As a trader MAs will help you decide which way to trade by looking at whether the price is above or below the moving average line.
If the price is above the MA line it acts as support: you could buy and enter a long position when the price pulls back to the MA line. You could then place your stop loss underneath the MA line.
Given the price is below the MA line it acts as resistance; You could then enter a sell order when the price retraces to the MA line and place your stop loss above the MA line.
Identify Trend Changes with Crossovers
The interesting thing about MAs is that they can be used alone or in combination with other MAs.
So when you place two MAs on one chart with different periods reflecting a short-term and a longer-term trend in price, you have the opportunity to trade MA Crossovers. They can be used to determine when a trend has changed direction.
When a shorter-period MA crosses above a longer-period MA it can signal that the trend is changing to the upside and it may be a good time to buy.
When a shorter-period MA crosses below a longer-period MA this is considered bearish: a signal that the trend may be changing toward the downside and it may be a good time to sell.
No matter which two time signals you use this principle will remain the same.
Summary
An MA is a lagging indicator that can help filter out the noise from random price movements to see the average value.
It can help identify the trend direction, determine support and resistance levels, and can help confirm trend-reversal when looking at MA crossovers.
It is important to understand the differences between the types of moving averages and how to tailor the time period to best fit the trend being followed, in order to gain the maximum benefit from this indicator.