A moving average (MA) is a simple technical analysis tool that smoothes price data to create a constantly updated average price. The average is taken over a specific period of time, such as 10 days, 20 minutes, 30 weeks, or whatever time period the trader chooses. There are benefits to using a moving average in your trading, as well as options for choosing the type of moving average.
Moving average strategies are also popular and can be adapted to any time frame, suiting both long-term investors and short-term traders.
Key Findings
- The moving average (MA) is a widely used technical indicator that smoothes out price trends by filtering out noise from random short-term price fluctuations.
- Moving averages can be constructed in several different ways and use different numbers of days for the averaging interval.
- The most common uses of moving averages are to determine trend direction and identify support and resistance levels.
- When asset prices cross their moving averages, it can serve as a trading signal for technical traders.
- While moving averages are quite useful on their own, they also form the basis for other technical indicators such as moving average convergence and divergence (MACD).
Why use a moving average
The moving average helps reduce the amount of noise on the price chart. Look at the direction of the moving average to get a general idea of which direction the price is moving. If it is directed upward, the price as a whole is moving up (or has been recently); is sloping downwards and the price as a whole is moving downwards; is moving sideways and the price is likely to be in a range.
The moving average can also act as support or resistance. In an uptrend, the 50-day, 100-day or 200-day moving average can act as a support level, as shown in the figure below. This is because the average acts as a floor (support), so the price bounces off it. In a downtrend, the moving average can act as resistance; like a ceiling, the price reaches a level and then begins to fall again.
Thus, the price will not always correspond to the moving average. The price may move through it a little or stop and turn around before reaching it.
Typically, if the price is above the moving average, the trend is up. If the price is below the moving average, the trend is downward. However, moving averages can have different lengths (discussed below), so one MA may indicate an uptrend and another may indicate a downtrend.
Types of Moving Averages
The moving average can be calculated in different ways. The five-day simple moving average (SMA) adds up the five most recent daily closing prices and divides the resulting value by five to create a new average each day. Each average is connected to the next, creating a single smooth line.
Another popular type of moving average is the exponential moving average (EMA). The calculation is more complex because it applies more weight to the most recent prices. If you plot the 50-day SMA and the 50-day EMA on the same chart, you will notice that the EMA reacts faster to price changes than the SMA due to the added weight of the latest price data.
Charting software and trading platforms do the calculations, so no math is required to use a moving average.
One type of MA is not better than another. At some times, the EMA may perform better in the stock or financial market, and at other times, the SMA may perform better. The time frame chosen for the moving average will also play an important role in how effective it is (regardless of the type).
Moving average length
Common moving average lengths are 10, 20, 50, 100, and 200. These lengths can be applied to any chart time frame (one minute, day, week, etc.), depending on the trader's time horizon. The time frame or length you choose for a moving average, also called the lookback period, can play a big role in its performance.
An MA with a short time frame will react to price changes much faster than an MA with a long analysis period. In the figure below, the 20-day moving average tracks actual price more closely than the 100-day moving average.
The 20-day moving average can be an analytical benefit for a short-term trader as it follows price more closely and therefore has less lag than a long-term moving average. The 100-day moving average may be more beneficial for the long-term trader.
Lag is the time it takes for a moving average to signal a potential reversal. Let us remember that, as a rule, when the price is above the moving average, the trend is considered upward. Therefore, when the price falls below this moving average, it signals a potential reversal based on this MA. The 20-day moving average will give much more reversal signals than the 100-day moving average.
The moving average can be any length: 15, 28, 89, etc. Customize the moving average to provide more accurate signals on historical data. Maybe help create better future signals.
Trading Strategies: Crossovers
Crossovers are one of the main moving average strategies. The first type is a price crossover, where the price crosses above or below the moving average, signaling a potential change in trend.
Another strategy is to apply two moving averages to the chart: one longer and one shorter. When the short-term MA crosses the long-term MA, it is a buy signal as it indicates an upward shift in the trend. This is known as the golden cross. Meanwhile, when the short-term MA crosses below the long-term MA, it is a sell signal as it indicates that the trend is moving down. This is known as the dead man's/death's cross.
Disadvantages of MA
Moving averages are calculated based on historical data, and nothing in the calculation is predictive in nature. Therefore, results using moving averages may be subject to chance. Sometimes the market seems to respect MA support/resistance and trading signals, and sometimes it shows no respect for these indicators.
One of the main problems is that if the price action becomes unstable, the price can fluctuate back and forth, causing multiple trend reversals or trading signals. When this happens, it's best to step aside or use another indicator to clarify the trend. The same thing can happen with moving average crossovers, where the moving averages become “entangled” for a period of time, causing many losing trades.
Moving averages work quite well in strong trending conditions, but poorly in volatile or range-bound conditions. Adjusting the time frame may temporarily resolve this issue, although these problems may occur at some point regardless of the time frame chosen for the moving averages.
Bottom line
A moving average simplifies price data by smoothing it out and creating one smooth line. This makes it easier to observe the trend. Exponential moving averages react more quickly to price changes than simple moving averages. In some cases this may be good, but in others it may cause false signals. Moving averages with a shorter analysis period (for example, 20 days) will also react more quickly to price changes than averages with a longer analysis period (200 days).
Moving average crossovers are a popular strategy for both entry and exit. MAs can also highlight areas of potential support or resistance. While it may seem predictable, moving averages are always based on historical data and simply show the average price over a period of time.
Investing using a moving average or any other method requires an investment account with a stock broker. Investopedia's list of the best online brokers is a great place to start finding the broker that best suits your needs.
