Technical indicators can make a big difference while trading. Among the most popular strategies used to indicate emerging and common trends is calculating the moving average (MA).
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What Are Moving Averages?
A moving average is simply a way to smooth out price fluctuations to help you distinguish between typical market “noise” and actual trend reversals.
Moving average lines for a given period don’t plot the price at a given moment. Instead, each point on these lines is the average closing price for a certain number of prior completed periods.
For example, at any given point in time, a 200-period Moving Average plots the average price over the past 200 periods. On a daily chart, the 200-period Moving Average is comprised of a series of average closing prices for the past 200 days.
As each new closing price is added, the oldest one is dropped from the calculation, hence the term Moving Average. In other words, what makes these Moving Averages is that for each new candlestick, the calculation replaces the oldest closing price with the latest one.
Moving Averages Type and Formula
It’s also important to note that there are two main types of Moving Averages (MA); exponential moving averages (EMA) and simple moving averages (SMA).
Simple Moving Average (SMA) Formula
The simple moving average (SMA) calculates an average of the last n prices, where n represents the number of periods for which you want the average:
SMA = (P1 + P2 + P3 + P4 + ... + Pn) / n
For example, a four-period SMA with prices of 1.2640, 1.2641, 1.2642, and 1.2641 gives a moving average of 1.2641 using the calculation [(1.2640 + 1.2641 + 1.2642 + 1.2641) / 4 = 1.2641].
While knowing how to calculate a simple average is a good skill to have, trading platforms like CAPEX WebTrader calculate this for you. Simply select the SMA indicator from the list of trading indicators, for example, apply it to the chart, and adjust the Moving Average period.
You typically adjust the indicators in the Moving Average Settings.
Exponential Moving Average (EMA) Formula
The exponential moving average (EMA) is a weighted average of the last n prices, where the weighting decreases exponentially with each previous price/period. In other words, the formula gives recent prices more weight than past prices.
EMA = [Close - previous EMA] * (2 / n+1) + previous EMA
For example. a four-period EMA with prices of 1.5554, 1.5555, 1.5558, and 1.5560, with the last value being the most recent, gives a current EMA value of 1.5558 using the calculation [(1.5560 - 1.5558) x (2/5) + 1.5558 = 1.55588].
As with the SMA, charting platforms do all the EMA calculations for you. Select the EMA from the indicator list on a charting platform and apply it to your chart. Go into the Moving Average settings and adjust how many periods the indicator should calculate, for example, 15, 50, or 100 periods.
Advantages and Disadvantages of Moving Averages
Moving averages act as a fundamental building block in many technical indicators, and they are conceptually critical to a host of trading concepts. However, no tool is without shortcomings, and potential investing assets can turn into liabilities if they are used incorrectly because traders fail to appreciate their limitations.
Advantages of Moving Averages (MA)
Moving Average indicators has two advantages over the other types of trend lines.
1. They clarify the trend direction
As a series of average prices over a given period rather than real-time prices, Moving Averages filter out random price movements and present a smoother, clearer picture of the trend for the period they cover versus the series of Japanese candlestick patterns. Because Moving Averages are dynamic and changing trend lines, Moving Averages can provide a useful look at the more subtle price fluctuations within the overall trend that hand-drawn straight trend lines or channels will miss.
2. They are often more reliable support and resistance lines
They are often more reliable support and resistance lines because everyone’s Moving Averages look the same: They’re built from an objective mathematical formula, so unlike trend and channel lines, a given type and duration of Moving Average for a given time frame looks the same on everyone’s chart and presents the same picture of trend and support/resistance for all viewing it. That is a valuable attribute. By watching the most widely followed Moving Averages and some of the best trading indicators, you have a better understanding of the moving averages and what the rest of the herd believes to be the support/resistance lines. That allows you to anticipate and exploit their moves.
Disadvantages of Moving Averages
The disadvantages of moving average analysis center around its simplicity and subjective flexibility.
Despite the fact that there are various types of moving averages, such as exponential moving averages (EMAs), that can be used to lessen data lags, moving averages inevitably give weight to historical values that may or may not be relevant now or in the future. A simple moving average cannot possibly capture changes in business fundamentals or the state of the economy because it gives the same weight to trading activity that occurred 10 trading periods ago as it does to trading activity that occurred yesterday. Trading requires a thorough understanding of all the important factors involved, not just the results of straightforward technical calculations.
Moving averages were developed by statisticians to describe time series data and identify trends. These time series' lengths and how those trends are interpreted both depend much on the individual. Some programs utilize moving averages of 14 days, while others might use moving averages of 50 minutes or six months. It can be very difficult to choose the best timescale to utilize, even after realizing that shorter moving averages tend to be more volatile.
Similar to how a moving average line must be properly understood, price action must be properly interpreted as well. This is because a moving average by itself cannot inform traders of what constitutes a substantial deviation or correlation. Prices are determined by the forces of supply and demand that buyers and sellers apply.
Moving averages are informative but never declarative due to their simplicity and subjectivity.
Moving Averages Examples
The 5-, 10-, 20-, 50-, 100-, and 200-period Moving Averages are widely followed in most markets and time frames. They are the standard sampling of shorter and longer-duration Moving Averages and provide a degree of self-fulfilling prophecy. They indicate support/resistance because traders believe they are support/resistance points.
The longer Moving Averages periods are particularly popular support/resistance indicators. For example, even the mainstream financial press aimed at laymen will usually mention if a major stock index crosses its 50- or 200- day Moving Average. Financial media will quickly note if a major pair hits or crosses one of the longer-duration Moving Averages like its 50-, 100-, or 200-day Moving Average. Similarly, because Moving Averages in longer time-frames are older, 20-, 50-, or 200-day, week, and month Moving Averages get more attention because they provide much more significant support/resistance than those durations in shorter time frames.
By all means, tinker with slight variations on these. For example, some prefer to shorten their sampling period to get a head start on the crowd (at the risk of getting a premature, false signal). Slightly longer or shorter sampling periods have their advantages and disadvantages. The following is a summary.
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Using Moving Averages in Trading
To understand and use Moving Averages in online trading, you need to understand the relative strengths and weaknesses of the longer- and shorter Moving Averages periods, and the older ones you’ll see on daily to monthly charts versus the younger Moving Averages in the shorter time frames.
Here’s what you need to know in order to decide what moving average setting to use.
Shorter durations (5, 10, 20 Periods) are more responsive to price changes, weaker, less significant support/resistance
- More responsive to price changes and quicker to indicate a change in trend.
- Are better at showing short-term trends.
- May provide warning of trend changes when they cross longer duration Moving Averages.
- Weaker, less significant support/resistance, so they don’t provide as reliable signals of trend continuation or reversal as the longer-duration Moving Averages when they are breached or when they hold.
- Shorter-duration MAs don’t display the overall trend as well as longer duration Moving Averages when prices are bouncing around because the shorter duration Moving Averages follow each price move so closely.
Longer duration (50, 100, 200 periods) are less responsive to price changes, stronger, more significant support/resistance
- Stronger, more significant support/resistance provides more reliable signals of trend continuation or reversal when they are breached or when they hold.
- They are better than the shorter-duration MAs at displaying the overall trend when prices are volatile because a more sustained trend is needed to move these MAs.
- The longer the duration, the further they lag the current price action.
Younger MA vs Older MA
The Same Advantages and Disadvantages Apply When Comparing Younger versus Older Moving Averages.
The same durations on longer time frame charts are older than those on shorter time frame charts. Thus a 200-day Moving Average is a much more significant support/resistance than a 200-hour Moving Average but is less responsive to price and trend changes.
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Examples of Moving Averages Behavior
Let’s look at some examples of how long- and short-term Simple Moving Averages behave. In the Figures below, the shorter the Moving Averages, the more closely they follow price. The longer the Moving Averages, the smoother they are, and the less often they tend to be breached.
This is a EURUSD weekly chart, meaning each candlestick shows a week’s price movement for the Euro-USD currency pair.
- Shorter-term Moving Average shows price changes faster than longer-term Moving Average: The shortest duration 10-period Moving Average (orange) follows the price more closely than the others, whereas the longer-duration 50 (green) and 200-period (black) Moving Averages are progressively more smoothed, with the 200-period Moving Average almost flat, reflecting how minimal the net price was over the period shown despite the volatility. That’s a potentially crucial point that you might have missed by looking at only the candles.
- Longer-term Moving Averages provide better support/resistance: The shorter-duration 10-week Moving Average is breached several times, far more often than the 50-week (two times) or 200-week.
- Shorter duration Moving Averages are less reliable support/resistance than longer ones.
Moving Averages Trading Strategies
Though you should watch the most popular Moving Averages, traders can and do experiment with less or more radical variations on these. Some will use slightly shorter duration Moving Averages when seeking more responsive trend lines to catch trend changes before the rest of the crowd but at a cost of catching more false signals. Others will opt for slightly longer durations to filter out all but the most proven trends. That may reduce the number of losing trades at a cost of missing some moves or accepting reduced profits on winning trades due to later entries and exits. The best moving average period for you will depend on your risk tolerance, skill level, ability to monitor trades in real-time, and thus your chosen time frame and trading style.
There are two common types of moving average strategies - crossovers used in the moving average method to signal trend reversals.
- The price itself crosses over or under a moving average.
- Shorter-duration moving averages cross over or under longer, slower-moving averages.
Each type signals changing the momentum that could be the start of a new trend.
Price Crosses Over or Under a Moving Average
The first moving average method and type of Moving Average crossover is when the price moves through an important moving average. For example, see the Figure below. When the price moves below its 50-period simple moving average or SMA, it’s a sign the trend may be moving lower. When the price moves above its 50-period SMA, it’s a sign that the trend may be reversing higher.
Two points to remember with this moving average strategy:
- Adjust your risk appetite to market conditions. If your technical analysis makes you confident in the trend, you should be more inclined to open partial positions based on whatever moving average crossover tends to signal the start of a trend.
- Which moving average should price cross over to give you a signal for a new trend? While we used the 50-period SMA in the example, that will depend on which one(s) you find provide(s) the best results: that is, those moving averages that provide signals early enough to catch most of the move, but not so early that you get more false signals than you’re willing to accept.
Moving Averages Crosses Each Other
The other type of trend reversal indicator using moving average crossovers is when:
- A shorter duration moving average crosses over a slower, longer duration moving average, signaling upward, bullish momentum.
- A shorter-duration moving average crosses under a slower, longer-duration moving average, signaling downward, bearish momentum.
The death cross and golden cross provide one such strategy, with the 50-day and 200-day moving averages in play. The bearish form comes when the 50-day SMA crosses below the 200-day SMA, providing a sell signal. Conversely, a bullish signal comes when the 50-day SMA breaks above the 200-day SMA.
What you need to know before using Moving Averages
Trading has nothing to do with discerning what logically should happen. Instead, it’s all about anticipating what the crowd will do and doing it first in your chosen time frame before they bid up to your entry price or bid down your selling price.
Don’t Think: What logically should happen?
Also, it is important to remember that you must confirm a signal in some way. If you are getting a ‘buy’ signal from an indicator and a ‘sell’ signal from the price action, you need to use different indicators, or different time frames until your signals are confirmed.
Another thing to keep in mind is that you must never lose sight of your trading strategy. Your rules for trading should always be implemented when using indicators.
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Before you start using technical trading indicators, you should consider using the educational resources we offer like CAPEX Academy or a demo trading account. CAPEX Academy has lots of free trading courses for you to choose from, and they all tackle a different financial concept or process – like the basics of analyses – to help you to become a better trader or make more-informed investment decisions.
Our demo account is a suitable place for you to get an intimate understanding of how trading and investing work – as well as what it’s like to trade with leverage – before risking real capital. For this reason, a demo account with us is a great tool for investors who are looking to make a transition to leveraged securities.