The moving average is one of the most commonly used technical indicators. If you spent even a little time looking at price charts, you have noticed that the price of an instrument moves up or down.
In fast-moving markets, you may find the price surging up only to plummet moments later.
Before surging again, it increases the potential for false signals.
Moving averages 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 uptrend conversely if the price is below the moving average line, we consider it to be in a downtrend.
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.
Traders will check to see whether the price is going towards moving average or bounce back or even break the regular support or resistance.
Often the price of an instrument will find support at the moving average line when the trend is up and find resistance when the trend is down.
Moving averages will tell you whether an instrument is trending up, down or if it's ranging. It will point if a trend is still in motion and whether it is reversing or losing momentum.
Bear in mind that moving averages are based on past prices and is known as a lagging indicator.
Therefore, it will not warn you, but it will confirm when a trend change is taking place. At the most basic level when the price crosses up and over the MA, traders take this as a signal to buy.
Similarly, when it crosses down under the moving average line, they consider it a signal to sell.
Types of Moving Averages
There are three main types: simple, weighted and exponential. We will discuss the simple moving average or SMA first and understand how it gets calculated and adjusts it according to the market conditions.
So let’s assume a plot of 10-day SMA, you would have the closing prices of the last ten days and divide by 10.
The calculation gives equal weights to each day, and it's called a moving average as all the prices dropped each time a new period becomes available.
It is ultimately pointing that the average is based only on the last X number of periods, in our example for the previous ten days. Have in mind that the longer the simple moving average period, the more it lags, and it will react slower to the most recent price movement.
We assigned equal values to all periods considered in our calculation the simple MA is slow to respond to rapid price changes that might be important. The easiest way to counter this is with another moving average.
Choose from weighted or an exponential moving average. Both types get calculated differently, but both give more weight to recent periods, and that's more emphasis on what trader.
As a result, weighted and exponential moving averages respond faster to price action by distributing more weight to recent periods and less to earlier periods.
They reflect a quicker sentiment shift which can be due to changes in supply and demand or significant news events that impact the traded instrument.
To illustrate the concept, if you were to plot an exponential moving average and an SMA on a chart, you'd see that the exponential moving average is closer to current prices.
Besides the type of moving average, you also have to decide on the time
Will largely depend on the kind of chart analysed by traders. Here are some guidelines for commonly used periods: 10 to 20 for short-term trends, 50 for midterm and 200 for long-term.
Depending on your objective, there are several situations where to use moving averages.
Use exponential moving averages for shorter timeframes if you're analysing the fast-moving market for more emphasis on the latest prices. Similarly, use simple MA if you're holding a position for a more extended period.
In this scenario, the exponential moving average might be too sensitive and give false signals.
Also, use SMA if you want to filter out noise from price fluctuations and determine the market direction.
Using Moving Averages
Moving Averages can be used to identify the direction of trends, entering and exit a trade. Finally bringing us to how to trade MA crossovers and determine the course of a trend.
Apply on your chart a simple moving average with a period 20 you will see uptrends and downtrends. Replacing it with a 60 SMA, you will notice a price range with no clear upward or downward trend.
The different direction of the pattern is due to the period. The more extended period MA will react to price changes much more slowly but will generally provide more reliable trading signals.
MA can help you decide which way to trade by looking if the price is above or below the MA.
Enter and Exit a Trade
If the price is above the MA, its consider as support where you can enter a long position. That’s of course, after the price pulls back to the MA line, and place a stop loss underneath the MA.
Similarly, if the price is below the MA, it acts as resistance. Enter a sell order when the price retraces to the MA line and place a stop loss above it.
What’s interesting about moving averages is that they can be used alone or in combination.
So when placing two MA with different periods, you will notice a short-term and long-term trading price. Such an approach will create the opportunity to trade MA crossovers.
Determine Trends by using MA Crossovers
For example, on a daily chart place a 10 SMA and a 20 SMA. When a shorter period MA crosses above the more extended period MA, it can signal a trend reversal.
The trend reversal will present a buying opportunity. It doesn’t matter which two periods you use the principle will remain the same. To learn more, please visit our EDUCATION section or Investopedia.com.
Like always, I wish you Happy Trading and Every Success!