body { font-family: sans-serif; line-height: 1.6; margin: 20px; }
h2 { border-bottom: 1px solid #eee; padding-bottom: 5px; margin-top: 30px; }
ul { list-style-type: disc; margin-left: 20px; }
Moving averages are among the most fundamental and widely used tools in technical analysis for traders and investors. They’re like the smoothing filter of market data, taking the sometimes erratic price movements and showing the underlying trend. Think of it as averaging the price of a stock or asset over a set period, which can give a clearer picture of whether the price is trending up, trending down, or moving sideways. This allows traders to cut out some of the noise and focus on the bigger picture, making more informed decisions. In essence, they help identify the direction of a trend and potential support or resistance levels, assisting in buying or selling activities.
What is a Moving Average?
Simply put, a moving average (MA) is a calculation that averages out the price of an asset over a specified period. For example, a 20-day moving average of a stock’s daily closing prices would be the average of the closing prices for the last 20 trading days. The “moving” part means that each day, as new data becomes available, the average is recalculated, dropping the oldest price from the period and including the newest.
Moving averages are plotted as lines on a chart, and they are typically overlaid on a stock price or other asset chart. The moving average line visually illustrates the overall price trend, making it easier to see if the price is generally increasing or decreasing, or stabilizing.
Types of Moving Averages
There are several types of moving averages, each calculated in slightly different ways and with their own characteristics:
- Simple Moving Average (SMA): The most basic form, the SMA calculates the average of prices over the specified period. Each price in the period is given equal weighting. It’s easy to understand and calculate, but its main weakness is that it gives less weight to new data.
- Exponential Moving Average (EMA): Unlike the SMA, the EMA places more weight on recent prices. This makes it more responsive to new price changes and is often favored for shorter trading time frames. However, this increased sensitivity can sometimes lead to more potential to react to short-term noise.
- Weighted Moving Average (WMA): Similar to the EMA, the WMA assigns extra weight to recent data points but uses a linear weighting scale. While it attempts to address the lag of the SMA, it is not as commonly used as the EMA.
The type of moving average you choose will depend on your trading style and what you want to see. The SMA is generally good for longer-term analysis while the EMA is faster to react to new changes and is suitable for short or intermediate-term trading tactics.
How to Interpret Moving Averages
Learning to use moving averages isn’t a game of just calculating them; it means interpreting and understanding them.
- Trend Identification: A rising moving average indicates an uptrend, while a declining moving average suggests a downtrend. If the moving average is relatively flat, it means the market is in a range or sideways movement phase.
- Crossovers: Crossovers between different moving averages can signal potential trading opportunities. For example, when a short-term MA crosses above a long-term MA (a ‘golden cross”), it is often seen as a bullish signal, indicating the start of a potential uptrend. Conversely, when a short-term MA crosses below a long-term MA (a ‘death cross”), it is considered a bearish signal, suggesting the start of a possible downtrend.
- Support and Resistance: Moving averages can also act as dynamic levels of support and resistance. In an uptrend, the price often bounces off the MA as support, providing potential areas to buy. In a downtrend, the price may meet resistance at the MA. Therefore, this might become an area to look out when the price is expected to start decreasing.
Choosing the Right Period for Your Moving Average
The period of a moving average is the number of data points (usually days) used to calculate the average. There’s a variety of periods that traders commonly use, and the selection depends heavily on what you’re trading and what time frame you’re following. Here are generally accepted guidelines:
- Short-Term Trading: Usually, short-term traders utilize 5, 10, or 20 period MAs. These shorter periods react quickly to price changes, making them ideal for picking opportunities in short time frames.
- Intermediate-Term Trading: Those trading on an intermediate time frame often opt for 50, or often 100 period MAs, as these offer a broader view of the trend while still being sensitive to price moves.
- Long-Term Investing: Long-term investors typically apply 200-period moving averages as they clearly represent very long-term trends.
The optimal period needs to be tested to see what works best for the specific market. It is not a one-size-fits-all solution and might require testing with various periods.
Limitations of Moving Averages
While moving averages are useful, they’re not flawless. It’s important for all traders to be aware of their limitations:
- Lagging Indicator: Moving averages are lagging indicators, meaning they are based on past price data rather than predicting the future. The longer the period the more the lag there will be. This means that by the time a moving average signals a trend change, the price may have already moved significantly.
- Whipsaws: In volatile or choppy markets, moving averages can generate many false signals, also known as “whipsaws”. For example, a price might quickly rise above a moving average, signaling buy for the trader, then dip below signalling sell. These short bursts of signals can be confusing for a beginner.
- Not a Crystal Ball: Moving averages should always be used in conjunction with other forms of analysis; it needs to be combined with other indicators and tools to give a clearer view.
Combining Moving Averages with Other Strategies
Expert traders rarely use moving averages in isolation. They often combine them with other technical indicators and chart patterns as part of a comprehensive strategy:
- Moving Average Convergence Divergence (MACD): A popular trend-following momentum indicator that often works well with MA’s in confirming buy and sell signals.
- Relative Strength Index (RSI): Used with MA’s to identify overbought or oversold conditions, confirming that the trend is likely to hold.
- Volume Analysis: Used along with MA’s to see if the amount of buying or selling activity supports the trend.
- Chart Patterns: Seeing whether the MA confirms the direction along with chart patterns such as triangles, wedges, and head and shoulders can provide valuable insight.
Using moving averages with other tools can provide a more robust and reliable method and reduce the possible number of false signals.
Conclusion
Moving averages are a fundamental concept in technical analysis and can become very effective tools for traders when they are fully understood and used correctly. By understanding the different types of moving averages, how to interpret them, and how to incorporate them into broader trading strategies (along with their limitations), traders can make informed decisions and manage risk more effectively. Remember that no tool is perfect, and moving averages should complement your overall trading approach rather than being the sole basis of it. Through practice and experience, traders can learn how to fully utilise the potential of moving averages in their own trading.
Frequently Asked Questions (FAQ)
This section contains some of the frequently asked questions about the use of moving averages.
- Q: Can a moving average predict the future?
A: No, moving averages do not predict the future. They’re based on past price data, making them lagging indicators.
- Q: What is the best moving average to use?
A: There is no single “best” moving average. It depends on your trading style and time frame.
- Q: Should I use an SMA or EMA?
A: Use SMA for longer-term analysis when you want a smooth trend line. Use an EMA if you require more sensitivity to price changes.
- Q: How can I avoid false signals?
A: Combine moving averages with other indicators and/or tools. Be patient and always test them in a demo account before using real funds.
- Q: Can moving averages be used in all markets?
A: Yes, moving averages can technically be used in all markets that have price and volume data, including stocks, forex, and commodities.
References
- Murphy, J. J. (1999).
Are you ready to trade? Explore our Strategies here and start trading with us!