Moving Averages

Moving Averages come in different varieties, all of them popular, and all of them useful for underpinning trend following systems and confirming other tools.

  1. Moving Averages Types

  2. Where You will Find Moving Averages Used

  3. Trade Examples

  4. Conclusion

 

You can’t talk about technical analysis without mentioning moving averages, because they’re quite possibly the most important and demonstrably the most frequently used kind of indicator out there. Moving averages are popular because many other types of indicators like the Moving Average Convergence Divergence (MACD) depend on them.

A moving average is sometimes used as a support/resistance line, and frequently as one component of a trend-following system. Its function is to average out a fluctuating price into a single convenient line that moves in tandem with it, smoothing out the peaks and troughs. It uses past prices as a basis for its calculations and this makes it a ‘lagging’ indicator.

Moving Averages Types

SMA

The two kinds of indicators that you see most often are the simple moving average (SMA) and the exponential moving average (EMA).

The SMA averages price for a specific time period, so for instance, if you had a 10-period SMA on your chart it would add together the last 10 closing prices and divide the result by 10, giving you your current SMA figure.

You will typically see periods of 50, 100, and 200 being used to explore longer-term market trends and they’re followed very carefully by traders and analysts. They consider the 50-period to be ‘fast’ as it’s more responsive to price, and the 200-period to be ‘slow’ as it’s less so, with the responsiveness of the 100-period sitting somewhere in between. Technical analysts will often give great weight to a clear break from a commonly followed moving average, so when a “fast” SMA crosses above or below a “slow SMA” they may take it as proof of a clear shift in the trend.

EMA

Some traders prefer the EMA or exponential moving average. Traders typically use the same time periods as they do for SMAs preferring it because it’s often more responsive to price action. It uses a greater number of multiplying factors than the SMA and describes greater importance to newer data points, giving traders and analysts more up-to-the-minute signalling.

The MACD indicator has made 12- and 26-day EMAs very popular in volatile markets, especially among day traders who tend to be market gadflies, entering and exiting positions swiftly in response to rapid price changes.

Where You will Find Moving Averages Used

Moving averages shouldn’t be confused with crystal balls. They can’t tell the future, because all they are doing is averaging out past data points to produce a line that might give you some clues about future movements. So, by the time you see a moving average slope flattening out the price action has probably already moved on because the indicator comes with an intrinsic lag.

If you use any form of support and resistance to come up with your entry points and you’re also looking towards moving average crossovers for confirmation to seal the deal, then unfortunately that ship will have already sailed by the time you react. Even if it returns to the same level the moving averages may have shifted again.

So, if you’re always missing the boat, what’s the point? Well, moving averages can still help you confirm trend direction or give you a visible measure of its size, so it’s more suited to a support role than one on the frontline.

Moving averages do find use by some traders as support and resistance levels, while others will use a mixture of different moving averages crossovers to confirm entry points of trend shifts. This is good basic practice, avoiding reliance on one or another tool, instead using an array of them. You’re looking for mutual confirmation between the majority of indicators before you place a trade, rather than just trusting one.

Moving averages are well-suited to trending markets. Traders pay particular attention to direction, slope, and rate of change. They are better visual cues than candles alone for spotting momentum shifts and trend changes.

It’s common for market players to only trade in the direction that the moving average has identified for the trend. For instance, if 50-, 100-, and 200-period moving averages all feature a positive slope, the trader may go long on every position.

Trade Examples

So, without depending on moving averages entirely for trade signals, you can run a system based on moving averages and also apply indicators to support and resistance. The result is that you will take trades around likely reversal points and in the general direction that the moving averages suggest.

Levels of support are areas that price will drop to before rebounding for long trades. Similarly, levels of resistances are areas where the price will rise and may reverse for short trades.

We’re going to use a crossover strategy to apply our moving averages, using periods of 10 (which is two weeks of trading days) and 42 (two months of trading days), with crossovers used to confirm trend changes.

We’ll also use an SMA rather than an EMA, but we can change this later if necessary. The 10-period SMA is our “fast” moving average, so-called because it will react faster to price in an uptrend than the slower EMA.

So, when the 10-period SMA crosses above the 42-period SMA, we get a bullish sign, and when it crosses below, we get a bearish sign, causing us to focus more on short rates.

Here’s a summary of our rules:

Long Trades

1. 10-period SMA goes over 42-period SMA

2. Bounce off a recent support level, as determined by previous price history

Short Trades

1. 10-period SMA goes under 42-period SMA

2. Bounce off a recent resistance level, as determined by previous price history

It’s a sign to exit a trade…

1. When the moving averages cross back, meaning the trend is over

or

2. There’s a break past the particular support or resistance level

 

Conclusion

The moving average is one of the most widely used indicators in trading, and it underpins the function of many other indicators too.

The SMA averages together all prices and the EMA gives weighting only to the most recent price information.

Trend following systems gain the most from moving averages, which offer the possibility of clear identification of a trend’s direction, its rate of change, and its magnitude. They have plenty of scope for price reversals and moving average crossover strategies too, and they are always best used in conjunction with other tools.