The two basic and most commonly used moving averages include the Simple Moving Average (SMA) and the Exponential Moving Average (EMA). The first is the simple average of a security over a defined number of time periods, while the second gives a greater weight to more recent prices.
- A moving average is a trend-following indicator based on past prices.
- A moving average is calculated by choosing certain periods and then dividing this number by the number of chosen periods.
- Moving averages can help in smoothing out of price action.
- Moving averages are used not only to identify the direction of the trend, but also for trade entry.
The two basic and most commonly used moving averages include the Simple Moving Average (SMA) and the Exponential Moving Average (EMA). The first is the simple average of a security over a defined number of time periods, while the second gives a greater weight to more recent prices.
The image below shows the SMA, which is formed by calculating the average price of a financial market over a chosen period of time.
Source: xStationThe EMA, as demonstrated in the image below, applies more weight and significance to most recent prices, and less weight to older prices in the chosen period.
Source: xStationThe image below shows a comparison between the SMA (blue line) and the EMA (orange line).
Source: xStationWhy use moving averages in trading
Moving averages are popular in technical market analysis, as they are able to smooth price data, form trend lines, and create an easily interpreted visual aid. They are especially well-suited for price charts and other indicators. Some of the advantages of using moving averages include:
- Moving average is used for forecasting goods or commodities with constant demand, where there is a slight trend or seasonality.
- Moving average is useful for separating out random variations.
- Moving average can help you identify areas of support and resistance.
- Simplicity of application and interpretation makes it possible to plot several different moving average lines at the same time.
- Moving average gives constant forecasts.
Disadvantages of moving averages
No method is perfect, and moving average comes with its own set of disadvantages. Moving average:
- Requires maintaining history of different time periods for each forecasted period.
- Often overlooks complex relationships mentioned in the data.
- Does not respond to the fluctuation that take place for a reason, for example cycles and seasonal impacts.
How to trade using moving averages
There are various methods of using moving averages in trading. Below we focus primarily on:
- Using one moving average
- Using two moving averages
1. Using One Moving Average
When one moving average is applied to the chart, then a buy signal is provided when the chart breaks the moving average from the bottom with the body of a candlestick. On the other hand, a sell signal is provided when the chart breaks the moving average from the top with the body of a candlestick.
Source: xStationIn the example above, a 50 period SMA was applied to Gold. As you can see, the market first provided a buy signal, after which the market gained in value. Later the market broke the SMA from the top providing a sell signal, after which the market lost in value.
2. Using Two Moving Averages
When two moving averages are used with two different periods, a buy signal is provided when the shorter term moving average breaks the longer term moving average from the bottom. On the other hand, a sell signal is provided when the shorter moving average breaks the longer term moving average from the top.
Source: xStationIn the example above, a 50-period SMA (blue line) and a 100-period SMA (white line) were applied on the DE30 chart. A buy signal was provided when the 50-period SMA broke the 100-period SMA from the bottom, after which the market gained in value.
Keep in mind, however, that all indicators and oscillators often provide false signals and should thus be used with other technical analysis tools. When all the tools you’ve used indicate the same direction for the market, this increases the probability of the success of the trade.
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FAQs
As a general guideline, if the price is above a moving average, the trend is up. If the price is below a moving average, the trend is down. However, moving averages can have different lengths (discussed shortly), so one MA may indicate an uptrend while another MA indicates a downtrend.
What is moving average method analysis? ›
A moving average (MA) is a stock indicator commonly used in technical analysis, used to help smooth out price data by creating a constantly updated average price. A rising moving average indicates that the security is in an uptrend, while a declining moving average indicates a downtrend.
What is the best moving average for analysis? ›
But which are the best moving averages to use in forex trading? That depends on whether you have a short-term horizon or a long-term horizon. For short-term trades the 5, 10, and 20 period moving averages are best, while longer-term trading makes best use of the 50, 100, and 200 period moving averages.
What are the 4 major moving averages? ›
The five most commonly used types of moving averages are the simple (or arithmetic), the exponential, the weighted, the triangular and the variable moving average. The significant difference between the different moving averages is the weight assigned to data points in the moving average period.
What is a significant moving average? ›
The 200-day moving average is considered especially significant in stock trading. As long as the 50-day moving average of a stock price remains above the 200-day moving average, the stock is generally thought to be in a bullish trend. A crossover to the downside of the 200-day moving average is interpreted as bearish.
How do you analyze a simple moving average? ›
This is done by adding the closing price of the security for a number of time periods and then dividing this total by the number of time periods, which gives the average price of the security over the time period. A simple moving average smooths out volatility and makes it easier to view the price trend of a security.
How to forecast using moving average? ›
To get the simple moving average (SMA) you would divide the total sales from January – March by the number of periods, which in this case would be 3 (3 months), giving you a simple average number of sales per month. This number can be used to forecast the sales of the upcoming months or period.
What is an example of a moving average? ›
Simple moving Average (SMA) To calculate the moving averages, we take the average of the closing price for those number of days. For example, a 20day simple moving average is nothing but the arithmetic mean of the 20 day closing price of the stock, similarly for 50day, 100 day and 200 day respectively.
What is the strategy of moving average? ›
A simple moving averages trading strategy is employed by traders to chart the price movement of a security and ignore the day-to-day price fluctuations. Traders can compare short, medium, and long-term trends over large periods. A 200-bar simple moving average is usually used as a substitute for the long-term trend.
What is the most successful moving average strategy? ›
The best way to trade moving average is to use the crossover strategy, where a shorter-period moving average crossing above a longer-period moving average generates a bullish signal, and vice versa for a bearish signal. This method helps indicate potential changes in the market trend.
While it is difficult to determine the absolute "best" technical indicators to support a basic moving average strategy, a couple of the most common ones are trendlines and momentum indicators.
What 3 moving averages should I use? ›
Typical settings for moving averages:
Long-term trend: 200 days (200 being roughly the number of trading days in a year) Medium-term trend: 50 days (50 being roughly 2 months of trading) Short-term trend: 9, 10 and 20 days.
How to interpret moving average? ›
The moving average can be used to identify buying and selling opportunities with its own merit. When the stock price trades above its average price, it means the traders are willing to buy the stock at a price higher than its average price. This means the traders are optimistic about the stock price going higher.
What is MACD strategy? ›
MACD strategy key takeaways
MACD is one of the most commonly used technical analysis indicators. It works using three components: two moving averages and a histogram. If the two moving averages come together, they are said to be 'converging' and if they move away from each other they are 'diverging'
How do you use moving averages to determine trend? ›
Once a moving average is calculated and plotted on a chart, it can be a powerful visual trend-spotting tool. If a moving average is rising, it can signal that a stock is in an uptrend. Conversely, when a moving average is falling, it can signal that a stock is in a downtrend.
How do you interpret a 50-day moving average? ›
The 50-day moving average is a straightforward strategy. If prices graze the average as support and then bounce back, a trader can buy a stock. If prices rise at this average as resistance and pull back, a trader must consider selling or shorting the stock before a further decline.
How do you interpret a 200 day moving average? ›
The trend mentioned here refers to the long-term trend of the given security. Stock traders use the 200 day moving average charts for finding the right opportunity to buy or sell an investment. For example, if the stock's price is trading above the 200-day moving average line, they may look for buying opportunities.
What does moving average mean in statistics? ›
In statistics, a moving average (rolling average or running average or moving mean or rolling mean) is a calculation to analyze data points by creating a series of averages of different selections of the full data set.
