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
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.
How do you analyze moving averages? ›
Look at the direction of the moving average to get a basic idea of which way the price is moving. If it is angled up, the price is moving up (or was recently) overall; angled down, and the price is moving down overall; moving sideways, and the price is likely in a range.
What is a good moving average? ›
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 meant by moving average analysis? ›
A moving average is a technical indicator that investors and traders use to determine the trend direction of securities. It is calculated by adding up all the data points during a specific period and dividing the sum by the number of time periods. Moving averages help technical traders to generate trading signals.
When to buy and sell using moving averages? ›
When the price comes down to the moving average and then rallies up again, this “bounce” could be used as a buy signal. On the flip side, moving averages can also help investors know when to sell a position. For example, if the stock's price rises to the moving average and bounces, this might be a sell signal.
What is the golden cross moving average? ›
What is a Golden Cross? A Golden Cross is a basic technical indicator that occurs in the market when a short-term moving average (50-day) of an asset rises above a long-term moving average (200-day). When traders see a Golden Cross occur, they view this chart pattern as indicative of a strong bull market.
What is the most profitable 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.
What is moving average for beginners? ›
The simple moving average is calculated by adding the price of a security over a period and then dividing that figure by the number of periods. For example, adding the closing prices of a security for the previous month and then dividing the total by the number of days in the month.
How accurate is a moving average? ›
) depends on the type of movement of interest, such as short, intermediate, or long-term. If the data used are not centered around the mean, a simple moving average lags behind the latest datum by half the sample width. An SMA can also be disproportionately influenced by old data dropping out or new data coming in.
The most popular simple moving averages include the 10, 20, 50, 100, and 200. Traders interested in Fibonacci numbers prefer to replace the popular moving average numbers with Fibonacci numbers. There are a number of moving averages each with different formulas.
What does a Bollinger band tell you? ›
Bollinger Bands, a technical indicator developed by John Bollinger, are used to measure a market's volatility and identify “overbought” or “oversold” conditions. Basically, this little tool tells us whether the market is quiet or whether the market is LOUD!
How to use moving average to forecast? ›
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.
How to interpret moving averages? ›
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 a simple moving average strategy? ›
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.
Is moving average a good indicator? ›
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.
Which is better, 50-day or 200-day moving average? ›
A longer moving average, such as a 200-day EMA, can serve as a valuable smoothing device when you are trying to assess long-term trends. A shorter moving average, such as a 50-day moving average, will more closely follow the recent price action and therefore is frequently used to assess short-term patterns.
What does 50-day and 200-day moving average cross mean? ›
The golden cross occurs when the 50-day moving average of a stock crosses above its 200-day moving average. The golden cross, in direct contrast to the cross of death, is a strong bullish market signal, indicating the start of a long-term uptrend.
How do you forecast using the moving average method? ›
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.
How do you analyze a 200-day moving average? ›
200-day Moving Average Strategy: You plot the 200-day price line and its 200-day MA. If the stock price is above the 200-day MA, it is a buy indicator. If it is below the MA, it's a sell.
