Moving averages are used to smooth price data in order to create a trend following technical indicator. Moving averages are not used to predict price movement, but are instead used to help confirm the current trend direction. Moving averages lag due to the fact the indicator is based on past prices. In despite of this lag moving averages are deemed useful as they both help smooth price action and filter out market noise. Moving averages also play an important role in the construction of a number of other technical indicators, such as Bollinger Bands, MACD and the McClellan Oscillator. The majority of traders either use Simple Moving Averages (SMA) or Exponential Moving Averages, a smaller minority of traders use Weighted Moving Averages but these won’t be addressed in this article.
Calculating Moving Averages: Simple Moving Averages and Exponential Moving Averages
A Simple Moving Average is calculated by working out the average price of an instrument over a specific time period, with the majority of moving averages being based on closing prices. For instance a 10 day Moving average is arrived at by adding up the closing prices of the previous 10 days, before dividing the total by 10. Old data is dropped from the moving average once new data becomes available, for instance at the end of the current days trading the oldest data point from our 10 day moving average will be replaced.
The calculation of Exponential Moving averages is more complicated and involves first calculating a simple moving average and then calculating the weighting multiplier, which then allows you to calculate the exponential moving average. Thankfully, the majority of trading programs will calculate both Simple Moving Averages and Exponential Moving averages for you, meaning that you don’t need to mess around with calculating moving averages unless you want too. Investopedia has a very good short video on the topic of Simple and Exponential Moving Averages which is worth a watch.
Moving Averages and Lag
The longer the time period used, the more lag you can expect from a moving average. While a 10 day exponential moving average is likely to hug price action closely, longer term moving averages are likely to experience some lag between shifts in price and significant changes in the moving average. It takes much longer for a 100 day moving average to change course or direction, due to the fact that the average contains much more data.
Picking a Time-frame
What time-frame to pick when using moving averages depends on your objectives. Short term moving averages are best suited to those taking a short term outlook in regards to a particular instrument, this is why the majority of retail Forex traders opt for short term moving averages. Those interested in medium-term trends typically tend to use 20-60 day moving averages, while long term investors will use moving averages of and in excess of a 100 days.
Different time periods are more popular than others, with long term stock traders the 200 day moving average is perhaps the most popular. The 50 day moving average is very popular among traders adopting a medium term outlook, with many traders using a 50 and 200 day medium average in conjunction with one another. In the past a 10 day moving average was very popular with short term traders due to the fact that it was very easy to calculate, however with the rise of computer trading short term traders now use a variety of different time-frames to trade.
Using Moving Averages to Identify Trend Direction
The direction of a moving average displays important information about prices, albeit with some lag. A rising moving average shows that prices are generally rising, while a falling moving average shows that prices are generally falling. Meaning that a rising moving average reflects a general uptrend and falling moving average reflects a downtrend.
Two or more moving averages can be used to generate crossover signals. The most popular crossover signals are double and triple crossover signals. Here we are going to focus on double crossovers, this signal involves using two moving averages. One relatively short term moving average and one longer term moving average. The general length of the moving averages determines the time frame of the system.
A bullish or golden cross occurs when the shorter term moving average crosses above the longer term moving average. Conversely a bearish or dead cross occurs when the shorter term moving average moves belong the longer term moving average. While crossovers are very easy signal to use, it is generally quite a late or lagging indicator. This is due to the fact that the two moving averages the signal uses themselves lag slightly behind price action.
Moving averages can also be used to create simple price crossover signals. Again these signals are very easy to use, a bullish signal occurs when the price moves above the moving average. A bearish signal occurs when prices move below the moving average. Again price crossovers tend to be a late indicator due to the fact that they use lagging moving averages.
Support and Resistance
Moving averages are occasionally used to produce support signals in an uptrend and resistance signals in a downtrend. For instance a short term upwards trend might find support close to the 20 day moving average. A longer term uptrend could for instance find support from the 200 day moving average. While this is one possible use for moving averages, the majority of traders tend not to use Moving averages to produce support and resistance signals.
As with all indicators there are pros and cons when it comes to using moving averages to generate trading signals. As moving averages are trend following they tend to lag behind price action, meaning such indicators will always be one step behind. This isn’t necessarily a bad thing, as many traders simply look to ride the dominant trend with moving averages give you a clear indication of the current trend. More problematic is the fact that moving averages tend to give you late signals when it comes to trend breaking down meaning that you may not exit positions as quickly as you would wish. You can’t expect to be able to buy at the very bottom and sell at the very top using moving averages, however you can still capture a large chunk of a trend. As with other technical indicators its a good idea to use moving averages alongside another technical indicator, with many traders using moving averages alongside the Relative Strength Index in order to determine overbought and oversold levels.