Moving Averages are used in technical analysis for eliminating market noises or spike i.e. back and forth moves like touch and go in a very short time and insignificant market moves i.e. slight corrective price action to identify the actual trend situation and also the support and resistance levels.
Moving averages and their crossovers signals are very commonly used for trading decisions.
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In speculative markets the prices change continuously and times there are sudden volatile spikes or insignificant moves against the ongoing trend. These spikes are insignificant as the price action does not sustain in that direction. A sudden drop in price may not necessarily indicate the beginning of a downtrend and in the similar way an upward jump may not necessarily mean the beginning of an uptrend. We need to smoothen out these noises of market to get the real picture of the underlying trends. We can achieve this by averaging out the prices for a decided time period, at every point of time.
What Are Moving Averages?
Moving average for the selected period of time is the average closing price during that period. If we are analyzing a daily chart then the simple moving average of 10 periods is going to give us the average of the closing prices of past 10 days. With each passing day the new closing price gets added and the data of the oldest days gets dropped off from the calculation of the moving average. The smoothed line that connects all of these averaging points is the moving average line.
There are various types of moving averages and we shall be talking about those towards the end of this write-up. The trading signals and decisions remain same with all the various types of moving averages but in this explanation we will be using the charts of simple moving average.
Like most technical indicators, moving averages are trend following and hence lagging indicators. Lagging indicators confirm the trend once the trend has already begun. These indicators do not predict the future market direction in advance.
Technical analysts use moving averages very commonly for price action forecasting. The explanation here is focused around Forex trading but the same concepts are applicable for other trading markets:
- Identification or confirmation of the trend.
- Identification of possible reversal points of the trends.
- Gauging the momentum of the trend.
- Identification of possible support and resistance levels.
We can use Moving Averages for the identification or confirmation of a trend. Bullish sentiments or uptrend is indicated when the moving average line is slopping upwards and the price action is continuously above it. Similarly bearish sentiments or uptrend is indicated when the moving average line is slopping downwards and the price action stays below it.
Please note that the above statements are just for initial guidelines because there are other factors and consideration which are important for the determination of a trend situation. The factors are as follows:
- Time frame of the chart: There may be a short-term uptrend on an hourly chart while there is a longer-term downtrend on the daily or weekly chart. Hence the time-frame of the chart we are analyzing is important.
- Period setting of the moving average: The price action may be showing bullish or bearish sentiments with reference to a shorter-time period moving average, say 5 periods, but may be indicating a different picture with reference to a moving average of a longer period setting, say 55-day moving average.
Please check the following Forex chart.
In the above daily chart please check the price action between point "A" and "B". The moving average line between these two points was slopping down and the price action was mainly staying below this line. This was indicating bearish sentiments or bearish trend. Between point B and C the moving average line started slopping upwards with the price action staying above it, and that indicates bullish sentiments or bullish trend.
The above example is also indicating the use of the moving averages as resistance and support levels. Between point "A" and "B" the resistance was coming near the moving average and between the point "B" and "C" the same moving average line turned into a support line.
Please note that the period setting of the moving average is again important. In some situation you may see that a 5-period moving average is acting as support or resistance and in some other situations the support or resistance may be at the moving average of some other period settings. There are no hard and fast rule or science about this as every situation is different and we need to analyze those differently.
When the moving average suddenly goes lower than the previous period, it may be a signal that the ongoing uptrend may be ending or a consolidation may be on the way. Similarly when the moving average suddenly goes higher than the previous period, it may mean that the downtrend is ending or a consolidation may be on the way.
Please check the following chart.
Please take a note of the pair of adjacent points i.e. “A” & “B”, “C” & “D” and “E” & “F” in the chart above with the moving average line in grey color.
- The left most part of the chart before point "A" is showing an upward move. Let's say that the it was an uptrend as daily prices were continuously staying over the upward slopping moving average line. The peak of this uptrend was at the point named as “Peak 1”. Let's assume that we had a long position during that time. Our trade would have given us the maximum profit if we could have closed the position at peak 1. But it is practically impossible to buy at the lowest level and sell at the peak.
- Now compare points “A” & “B” on the SMA line. Till point “A” the SMA line was sloping upwards. During the next period (day in this case as this is daily chart) the point “B” on SMA line is lower than the point “A”. That means the moving average on the next day was lower than that of the previous day. This was an indication that the price-action may reverse the direction or go down for a consolidation. In fact this proved to be a true signal as a downward correction extended after point "B" and the downward move continued for next 15 trading days. Hence at this first indication we should have closed our existing long position.
- Points “C” & “D”: Similar to the example above in point #1, the point marked as "Peak 2" was the lowest point during the downward move. The moving average line changed the direction after that. The moving average at the point "D" had gone higher than what was at point "C". This fact indicated a possible upward correction or even a reversal of the trend.
- Points “E” & “F”: Moving average point “F” went down a bit than that of point "E". This signaled a possible downward correction or even the possibilities of reversal of uptrend. In one way it could be considered as a false signal as the upward gains continued after a slight drop but if we really observe we would see that the signal for downward move (point F lower than point E) was on April 4th and the uptrend resumed around April 17th. Hence, if we would not have closed our position, we would have had almost 2 weeks running into negative with our money stuck up and not usable for entering any other position.
Let's see how to use moving averages in technical analysis:
► Comparing moving averages with actual prices directly:
If the price action has been staying on one side of the moving average line and suddenly crossed to the other side then a change in the trend is indicated.
► Comparing two or more moving averages of different time period for example for period 5* and period 22*:
A change towards bullish sentiments is indicated if the shorter-term moving average line crosses over the longer-term moving average line. The opposite is true i.e. an emergence of bearish sentiments is indicated 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 moving average line.
Crossover of Moving Averages and Price Action
As mentioned above that is the price action has been continuously below the moving average line and then break over this then a bullish or buy signal is generated. The opposite of it would be a bearish or sell signal which is when the price action moves below the moving average line after being above it for an extended period of time.
Please note that the moving average with shorter period setting would generate higher number of signals and the number of false signals would be more. We would recommend to use 5-period, 22-period and 55-period moving averages. On a daily chart the 5 period represents 5 days and hence a trading week, the 22 day represent a trading month. 55-day moving average and 200 day moving averages are commonly used in the technical analysis.
It is always better to wait for some time to see if the price action is sustaining the crossover than to take a position immediately after the crossover.
In double crossover method we use moving averages of two different time periods.
When the short-term moving average crosses over the longer-term moving average, it is an indication that the recent price action is moving upwards. This crossover can be considered as a bullish signal.
When the short-term moving average moves below the longer-term moving average, it is an indication that the recent price action is moving downwards. This crossover can be considered as a bearish signal.
Please check the following to see the double crossover signals:
The green line is for the moving average for 10 periods and the red one is for 20 periods 2. At the point “A” the line for 10 periods has crossed the line for the 20 periods 20 and moved up. This gave a bullish signal. The signal proved to be true as there was strong upward move thereafter.
At the point "B" the moving average line for 10 periods went below the line for 20 periods. This indicated that the upward move has lost the momentum and we can expect some downward correction or a reversal of the trend.
Please also note the frequent crossovers on the left hand side when the price action was in a very narrow range. Crossovers during that time were false signals. This also highlights the point that till a real breakout of a narrow range takes place, crossover signals cannot be trusted.
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 may also compromise some good signals because we wait for too long for a reconfirmation. Another fact which goes against this method that if the trend is weak in the momentum, by the time the second crossover takes place, the price may already be on the verge of peaking.
Please see the following Forex chart for a visual explanation.
In the chart we have used three moving averages, one for 4 periods (green line), second for 9 periods (white line) and third for 18 periods (red line). In this method we take a trading action when the line for the shortest period crosses both the other moving average lines.
At point “A” the moving average (4) crossed the line for period 9 and gone below. This could be a signal for further downward move and we could have gone 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 18 periods and went below it. Here i.e. at point "B" we entered the short position. The second crossover was for the confirmation of the fall.
Similarly we did not enter a long position at point “X” when the moving average for 4 periods moved over the moving average for 9 periods. 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 was 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.
Note: Please note that the concept of crossover signals does not depend on the type of the moving averages but remains same for all the types.
We have detailed explanations of different types of moving averages on separate pages but the overview the common moving averages is as follows:
1) Simple Moving Average (SMA)
The Simple Moving Average (SMA) uses the arithmetic mean of a given set of values. If 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 the weight or importance given to the oldest data is same as the newest. Logically with a moving average the recent data should be given more importance as it may be indicating a new emerging trend.
2) Linearly Weighted Moving Average (WMA)
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. So the importance or weight for the most recent data point of 10th day will be 10 and the data prior to that will have a weight or importance factor of 9 and so on. This makes WMA more sensitive to the more recent price movement.
Read about Weighted Moving Average.
3) Exponential Moving Average (EMA)
In technical analysis the EMA is more popular that SMA and WMA.
Let’s see how EMA is different from WMA:
"Linear growth" means that the original value increases by a set amount. "Exponential growth" means that the original value increases by a set percentage. Read about Exponential Moving Average
For a visual explanation please see the figures below.
Hence unlike WMA, in which the weight is reduced linearly for older data, in EMA the weight is reduced exponentially or by percentage i.e. more recent data has much more weight and older data has much less percentage weight.
You may also check Moving Average Convergence Divergence).