Moving Averages are used in technical analysis for neglecting market noises or the sudden spikes in the price action to identify the real trends and also the support and resistance levels.
Moving averages and their crossovers are very commonly used for trading decisions. Please note that the explanation is focused for Forex trading but this a valid for stocks or any other commodity trading.
In speculative markets the prices change continuously and many times with high volatility. A sudden drop in price may not necessarily indicate a downtrend and in the similar way an upward jump may not necessarily mean the beginning of a uptrend. We need to smoothen out these continuous noises of market i.e. these continuous up and down movements to get the real picture of the underlying trend. We can achieve this by averaging out the prices for a decided time period, at every point of time. Please read the explanation of moving average as follows.
Moving average for the selected period of time is the average price during that period. Say we are analyzing daily chart then the simple moving average of 10 periods is going to give us the average of the last 10 days. As during any particular trading day the price movement can be substantially high and hence we can consider the closing prices of the trading days for calculating the average. With each new day, it adds that day’s price to the data and drops off the oldest day’s price data to calculate the new average. The smoothed line that connects all of these averaging points together and gives us the moving average line.
There are various types of moving averages and we shall be talking about those towards the end. Please note that before we talk about different types, we shall be using SMA (Simple Moving Average) as example in the charts and examples below. We also have the explanation about other types of averages e.g. EMA (exponential moving average) and WMA (weighted moving average).
Moving averages are among the most popular and widely used technical analysis indicators. These can help us in avoiding the confusion about the actual trend when market takes some small corrective actions. By small corrective actions we mean a small amount of retracement in the opposite direction of the ongoing movement or the current market trend. With moving averages we can visualize and measure market trends. Like most indicators in technical analysis, moving averages are trend following/lagging indicators. Trend following or lagging indicator does not predict the future market direction in advance rather it confirms the trends once they have begun.
Technical analysts use moving averages very commonly for price action forecasting. Though we will be using examples of moving average analysis in Forex trading but the same is true for other markets. Some of the common usages are as follows:
We can use Moving Averages for confirmation of a trend. For example, when the closing prices of the subsequent periods are continuously above the moving average line and the line is in sloping upwards, it confirms that the market is bullish and it may be good to go for a long (buy) position.. Similarly when the closing is continuously below the moving average line and the line is sloping downwards, it indicates that the market is bearish and we can go for short-selling.
Please check the Forex chart below:
If you look at the chart for EUR/USD above, you will see that during the downtrend indicated by the red arcontainer on the left hand side, the SMA line is sloping downwards. Also the closing prices for periods are most of the time staying below the simple moving average line. This is indicating a downtrend between point A and point B. After point B an uptrend is starting. This is being confirmed by the SMA line sloping upwards and most of the times the closing prices remaining above the SMA line.
We can also use this indicator to know the support and resistance levels. When the prices hit the moving average line, they often stop and reverse. You will notice that during an uptrend whenever there is a downward move and it reaches near the moving average line, or attempts to break below it,, there is an upward jump again. Similarly during a downtrend whenever there is an upward correction towards the SMA line there may be a resistance near the SMA line and then the downward move continues. Please see the chart 1 above for a better visual understanding.
When the moving average suddenly goes lower than the previous period, it may be a signal that the ongoing uptrend may be ending. Similarly when the moving average suddenly goes higher than the previous period, it may mean that the downtrend is ending.
Please see the Forex chart below:
Please check adjacent points “A” & “B”, “C” & “D” and “E” & “F” in the above chart with Simple Moveing Average shown in grey color.
Let's see how to use moving averages in technical analysis:
► Comparing moving averages with actual prices directly:
Price action is falling below the moving average line of moving above it will indicate the change in the trend. If the price action is crossing the moving average to go up then it would show a bullish sentiment. The opposite of it would indicate that bearish sentiment may be coming into the picture.
► Comparing two or more moving averages of different time period for example for period 5* and period 22*:
If short-term moving average line is crossing over the longer-term moving average line then it would indicate that a bullish sentiment is coming to the picture. The opposite is true when the shorter-term moving average becomes less than the longer term average and hence the short-term moving average line goes below the longer-term line to indicate a bearish pressure.
(*Period: Period 5 means the average for past 5 days on any given day on “daily chart” and on hourly chart for past 5 hours on any given hour. If we are using daily charts then 5-day moving average will represent the weekly moving average and 22-day moving average will represent the moving average for a month.)
The closing price for a period going above the moving average line can be interpreted as a buy signal. Similarly the closing price going below the moving average line can be interpreted as a sell signal. This crossover concept is explained earlier in this section.. Please refer the charts in the beginning of this write-up.
If we use moving average of short period (5 periods or 10 periods) the prices will tend to be closer to the MA line. Moving average of shorter periods will give more number of signals than the longer term averages, say 22 period or 55 period or even 200 periods as in the famous 200 day moving average. The point to be considered is that many of those signals may prove to be false.
Please also note that the signals from longer term moving averages work better while when the market is trending (uptrend or downtrend). When there is a reversal of trend then initially a shorter term time-frame may work better.
To avoid false signals, you may like to get a better confirmation by waiting for some extended time and not taking a trading decision as soon as the crossover takes place.
Let’s In Double crossover method we use moving averages of two different time periods.
Let’s say that the moving average line for past 5 days (trading week) is moving above that of past 22 days (trading month). What does it imply? It implies that the prices during the past 5 days have been going up or in other words the market is becoming bullish.. Similarly if the shorter term moving average is going below the longer term MA line, this may be a signal that there may be a fall and a downtrend may start. This can be taken as a “sell” signal.
Please note that the crossover signals are not only for SMA but for EMA and WMA also, which are explained in other chapters (please find the links at the bottom).
The momentum of the movement can be measured by using multiple moving averages of different time periods. In double crossover method we use two moving average lines with different time periods and look at the divergence i.e. which one is going up or down.
Please check Forex chart 4 below to see how the crossovers of shorter time frame and longer time frame moving averages generate buy or sell signals:
The green line is for Period 10 and the red line is for period 20. At point “A” the line for period 10 has crossed the line for the period 20 and moved up. This gave a “buy” signal that there may be an upward movement. This proved to be correct as there was a rally and a jump upwards.
Similarly at point B the line for period 10 has crossed the line for the period 20 and went below indicating that the upward move has lost the momentum and we may expect some downward correction or a reversal of the trend. This crossover gave a “sell” signal.. Please also note the frequent crossovers on the left hand side when the price action was in a narcontainer range. Crossovers during that time were false signals.
As the name suggests, here we use three moving averages for different time periods. This method provides fewer but more surer signals. While we say surer signals, we also compromise on the fact that the signal may come little late.
Please see Forex chart 5 below for a visual explanation.
In the above Forex chart we have used three moving averages. One for period 4 (green line), second for period 9 (white line) and third for period 18 (red line). In this method we go for the r signal when the line for the shortest period crosses both the other lines.
At point “A” the moving average (4) crossed the line for period 9 and gone below.. This could be a signal that further downward move may take place and we could go for a short selling position. But we waited till point “B” when this line i.e. for period 4 also crossed the moving average for period 18 and wend below it. Here i.e. at point "B" we entered the short position.
Similarly we did not enter a long (buy) position at point “X” when line for period 4 crossed the line for period 9 and went above it. We waited till point “Y” when this line ( period 4) also crossed the line for period 18. This increased the probability of the signal being true.
In the above example we used the periods 4, 9 and 18 but that is just to explain the concept and not as strategy. In different kinds of market movements and volatility situations we need to work out with different combinations. One of our favorite combinations is to use period 5, 22 and 55.
We have detailed explanations of different types of moving averages on separate pages but the overview the common moving averages is as follows:
The Simple Moving Average (SMA) uses the arithmetic mean of a given set of values. f we use SMA of period 10 on a daily chart that would mean the average of the closing prices for each day for past 10 days. The average is 'moving' as when new data comes in the oldest data would be replaced by the new value.
The drawback of SMA is that it gives equal weight to all old data points as well as most recent data. Some technical analyst feel that more recent data should have more weight.
The linearly weighted moving average (WMA) gives more weight to more recent data. For example, using a day 10 moving average the 10th day would be multiplied by 10, the 9th day by 9 and so on. This makes WMA more sensitive to the more recent price movement.
Read about Weighted Moving Average
In technical analysis the EMA is more popular that SMA and WMA.
Let’s see how EMA is different from WMA:
"Linear gcontainerth" means that the original value increases periodically by a set amount. "Exponential gcontainerth" means that the original value increases periodically by a set percentage. Read about Exponential Moving Average
For a visual explanation please see the figures below.
So unlike WMA, in which the weight is reduced linearly for older data, in EMA the weight is reduced exponentially i.e. more recent data has much more weight and older data has much reduced weight.
We explained Moving Averages as technical analysis indicators in the context of "Forex Trading" but the same stands good for stock trading or any commodity trading.
You may also check Moving Average Convergence/Divergence).
