What is a Moving Average (MA)?
Finding out the direction of a price trend is a challenging task. Moreover, short-term price changes called market noise, can distort the overall trend. This is why analytical tools like the moving average are helpful to see trend movement.
What is a Moving Average (MA)?
A moving average (MA) is a technique used to define the direction of a price trend over a particular period. The moving average strategy is popularly used in technical analysis by traders and investors. This is due to its ability to smooth out price trends and define them amidst market noise.
Moving averages have been developed and used by statisticians in data analysis since the early 1900s. In the 1970s, Gerald Appel applied MAs to create a trading indicator known as the moving average convergence/divergence (MACD).
The moving average is a good indicator that signals the trader or investor to make decisions. It works by evaluating the averages of data points of a financial asset. These averages are obtained by summing up the data points and dividing the sum by the number of points over a given period.
MAs are represented on price charts as squiggly lines that follow the movement of the candlestick pattern. They are called "moving" because the averages change as the price move. They are also called lagging indicators, as they tend to trail behind the new price action of the financial asset. As a result, they give a signal or the trend's direction.
👍 Pros of MAs
• Moving averages are used for predicting the price trend of a financial asset. Thus, signaling the trader or investor to take action.
• A moving average helps smooth out random short-term price fluctuations or volatility.
• It can help you spot areas of support and resistance for trends that have no direction.
• MAs are simple to implement and interpret. Hence, you can plot more than one on a chart to understand the price momentum further.
👎 Cons
• Moving average is a lagging indicator. Hence, it needs continuous maintenance of the history of different periods to predict the trend. This is a problem for short-term investors or traders.
• It tends to be insensitive to some occurrences in the assets data. For instance, fluctuations that occur for a reason, like seasonal impact or cyclic patterns.
• MAs are simplistic and frequently overlook complex occurrences arising from the data.
• It tends to be insensitive to fundamental factors — like the news or events— that can also influence the price.
Main Types of Moving Averages
Many types and applications of moving averages exist in the world today. However, there are two main types of moving averages used:
Simple Moving Averages (SMA)
The simple moving average (SMA) is the most straightforward moving average. It calculates the average or means of a specific number of data points (closing prices) within a given period. This is evaluated by adding the recent data points and dividing the sum by the number of periods.
An SMA is a lagging indicator as it depends on the previous price data for a specific time. Also, it only calculates the arithmetic mean of closing prices, so it may not be sensitive to the weight (significance) of individual prices. It is customizable and can be calculated for various prices, whether high, low, open, or close.
The SMA indicator helps traders produce trading signals, alerting them to enter or exit a trade. While in financial markets, the SMA assists investors and analysts in deciding when to buy or sell a financial asset. Typically, short-term averages are more sensitive to price changes of the underlying asset than long-term averages.
The SMA is represented on the price chart and helps identify support and resistance prices to obtain signals on where to enter or exit a trade.
To produce the SMA, traders must first calculate the average and plot it on a graph.
The Simple Moving Average formula is as follows:
SMA = (X1 + X2 + …...Xn) / n
Where:
Xn is the price in period n
n is the number of periods
For example:
The closing prices for a security in the last ten days are as follows:
Week 1: $23, $23.40, $23.20, $24, $25.50.
Week 2: $20, $22.1, $28.7, $26.5, $21.9
The SMA is then calculated as follows:
SMA for Week 1 = ($23 + $23.40 + $23.20 + $24 + $25.50) / 5
SMA = $23.82
SMA for Week 2 = ($20 + $22.1 + $28.7 + $26.5 + $21.9) / 5
SMA = $23.64
A 5-day moving average would get the average/mean of the closing prices for the first 5 days as the first data point. Moving forward, the average from day 6 would be obtained, and so on.
The chart below shows the SMA of a 20, 200 period:
Exponential Moving Average (EMA)
An exponential moving average (EMA) is a type of moving average that shows price momentum over time like the SMA. Typically, it also smooths out the price trend of an asset and calculates the averages of prices within a given period.
However, EMA puts weight and significance on the most recent data points. So, it is more responsive to price fluctuations. This sensitivity is a factor that distinguishes EMA from SMA. This factor is beneficial but also carries a risk, especially for long-term traders. Though EMA identifies trends faster than SMA, it can be influenced by short-term fluctuations. Day traders may find this factor helpful, but not long-term traders.
The 200-EMA in this price chart below shows a better reaction to the apparent decline in price.
To calculate EMA:
1. Obtain the simple moving average for the specified period.
SMA = (N−period sum)/ N
where:
N = number of days in a particular period
period sum = sum of asset closing prices in that period
2. Calculate the multiplier for weighing the exponential moving average.
Weighted multiplier (k) = 2 ÷ (selected time period + 1)
Assuming the time period is 20 days;
k = 2÷(20 + 1)
k = 0.0952
k = 9.52%
Thus, the EMA will weigh the current price by 9.52%.
3. Calculate the current EMA by taking the period from the initial EMA until the most recent time period, using the price, multiplier, and the previous period's EMA value.
The formula is:
EMA = Price (p) × k + EMA (y) × (1−k)
Where:
p = today's price
y = yesterday's price
N = number of days in EMA
k = 2 ÷ (N+1)
The smoothing constant K applies reasonable weight to the most recent price.
You may notice that the EMA uses yesterday's EMA price value in its calculation. This implies that the EMA includes previous price data to the current price.
Moving Average Based Indicators
Envelops
Envelopes are technical indicators that are typically plotted above and below a price chart.The moving averages form the upper and lower price range levels. Also, they are is set at the same percentage to create equal widths. This produces parallel lines that follow price action.
Envelopes assist traders and investors in spotting extreme overbought and oversold situations when the trend lacks a direction. The asset price is overbought when it reaches the upper level, creating a sell signal. But if the price hits the lower level, it is seen as oversold and produces a buy signal.
Moving Average Convergence/Divergence (MACD)
The Moving Average Convergence/Divergence indicator is a momentum technical indicator mainly used to spot changes in a price's direction. It is seen in the chart as two lines that oscillate without borders. These lines represent the moving averages that follow the trend.
"Convergence" means the moving averages are moving closer to each other, while "divergence" implies that they are moving away.
The MACD indicator consists of:
-
The signal line, which follows price trends to spot changes and generate trade signals.
-
The MACD line, which evaluates the distance between the two moving averages
-
The histogram, which shows the difference between the MACD and the signal line.
Subtracting the 26-period moving average from the 12-period moving average will form the MACD line, while the 9-period moving average of the MACD is the signal line. The difference is then described with the histogram. The crossing over of the two moving averages generates trading signals. If the MACD crosses over the signal line from below, it indicates a buy signal. If it crosses over the signal line from above, it gives a sell signal.
MACD indicator
What Type of Moving Average to Choose?
Moving averages are common in the finance world. They are easy to implement and flexible to suit a trader's needs when it comes to identifying the actual price trend. There are other kinds of moving averages to choose from apart from SMA and EMA. Some of them include Weighted Moving Average, Double Exponential Moving Average, Triple Exponential Moving Average, Least Square Moving Average, and so on.
To choose a movie average depends on the timeframe and your trading strategy. The different kinds of MA work differently in identifying price trends and generating trade signals. Also, MAs can be designed to work within a specific timeframe. So, they can affect trade.
MAs can work better as indicators by themselves or combined with other indicators. Examples of indicators that employ moving averages include MACD, Bollinger bands, Envelops, Average Directional Index, etc. Moving average-based indicators respond to market volatility differently. Some are more sensitive than others. Short-term traders tend to use sensitive indicators with shorter timeframes to detect price fluctuations. In contrast, long-term traders may prefer indicators that have long timeframes and work to evaluate long-term price changes.
Top 3 Moving Average Strategies
Moving Average Crossover Strategy
One benefit of moving averages to beginners is the simple visualization and interpretation of price trends. The 'cross' is the most notable.
This strategy is less complicated and can be mastered by beginners. The Single MA Cross and Double MA Cross are the popular crossover strategies.
The Single MA Cross
First, choose your timeframe in this strategy—for instance, a 10, 20, 50, or 100-period. Then, plot a single MA line on your trading chart.
Over the time period, the market price may cross the MA line from below. This indicates a "golden cross" or bullish cross and a buy signal. On the flip side, if the price crosses the line from above, it is known as a "death cross" or bearish cross and signals you to buy.
50, 200 ma cross
The Double MA Cross
This strategy uses two MA lines instead of one and market price. One line is set with a short timeframe, while the other is for long-term. The long timeframe MA line helps to show you a bigger picture of the market price, while the shorter one shows price changes.
The Double MA cross gives the same trade signals as the Single MA Cross, only that it involves the two MA lines.
When the shorter MA crosses the longer MA line from below, it is a golden cross. When the shorter MA crosses the longer MA from above, it is a death cross. The Double MA Cross improves the Single MA strategy by using a MA line with a longer timeframe.
If the cross is bearish, place your stop-loss order above the price top firmed on the chart.
If the cross is bullish, you should put a stop-loss order below the bottom formed on the chart. You can choose to close your trade and collect profits when in a price breakout or wait for a cross.
Moving Average Convergence Divergence (MACD) Strategy
The MACD strategy implements the MACD indicator. As described earlier, The MACD consists of two EMAs (MACD line and signal line) and a histogram. You can employ many strategies within the MACD strategy, including the crossover.
Moving Average Envelop strategy
The envelop strategy manages the risk of unexpected price volatility by adding two bands above and below the MA line. The bands are calculated lines, set at the same percentage to give equal width. They provide support and resistance to the chart so that when the price breaks out, it provides a signal to enter the market.
If the price crosses the band above the MA, it is a signal to buy. If it crosses the line under the MA, it is a sign to sell.
Envelope indicator
Moving Average Setups
Before setting up and using moving averages, you need to consider certain factors. Firstly, decide which trading strategy is convenient for you, whether day trading, swing trading, or long-term trading. Then, you select which type of MA to use and clarify the reasons for using moving averages.
As a beginner, it would be best to stick to popular moving averages to get good results. If you are a short-term or day trader, you need to choose sensitive MAs that are swift to react to price changes, such as EMA's. In terms of period and length, the lesser the period, the faster the MA reacts to price changes.
The 9, 21, and 50 periods are the common moving average setups for day traders. Swing traders who use longer timeframes and hold trades for longer periods. So, the SMA and longer time periods are more suitable. Common periods for swing traders are 20, 50, 100, and 200 periods. The 50 period is the most popular among swing traders as it sits in the middle of short- and long-term trading.
How to Combine Moving Average with Other indicators
Indicators are useful to help generate signals for traders. It is even more profitable when you combine them in the right way. Before combining indicators, ensure that you understand what they entail.
Usually, factors to consider before combining indicators include:
-
Principles on which the indicator is based and its purpose;
-
Market conditions, like price volatility and fundamental factors;
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Trade management;
-
And Entry and exit trigger.
Examples of Strategies That Combine Indicators
Momentum Indicators
Momentum indicators, like the MACD or average directional index (ADX), to show imminent price change and trend direction. They are good examples of indicators that traders use to combine MAs. Momentum indicators are also refered to as oscillators. This is because they cycle above and below a middle zero line, representing the gain or loss of a trend’s momentum.
Trendlines
Trendlines are indicators that give signals when a market price is in trend or when it has entered a ranging area. Trendlines are used as additional indicators that prove market price direction. Thus, they are combined with MAs to improve trend forecasting.
Best Brokers To Consider
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IG is a well-regulated brokerage company established in 1974. It is a trading platform for many assets but mainly forex and CFDs. IG offers excellent education, trading, and research tools. Also, you can create and implement indicators during a trade.
On the flip side, IG permits a high minimum rate. Also, beginner traders may find CFDs to be a complex security.
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Interactive Brokers
Interactive Brokers is a brokerage company that offers a wide range of financial securities, including stocks, bonds, options, forex, and cryptocurrency. It was established in 1993 and is well regulated.
Interactive Brokers is considered to be one of the best brokers for professional traders and sophisticated traders. So it may not be suitable for beginners.
Interactive Brokers Fees ReviewFAQs
What does the moving average tell you?
A moving average helps you spot the direction or momentum of a price trend. The averages obtained from the price data points aid in smoothing out the price trend and filtering out the market noise. It can generate signals that tell you when to buy or sell an asset.
What is a good moving average?
A good moving average is the one that is suitable for you. There are many types of MAs with characteristics that suit different strategies. So, it would be best if you defined your strategy, then select the MA that suits your preferences.
Why Is moving average important?
Traders and investors may not accurately pinpoint the trend direction of a market price. So, MAs serve as tools used to interpret price data and define the trend movement. This is important for traders to make better reading decisions.
How are moving averages used in investing?
Investors use MAs to know when to trade. Signals generated by MAs tell you where the trend is heading and when to enter or exit a market. MAs with longer periods are used by long-term investors, while short-term investors use those with shorter periods.
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Team that worked on the article
Chinmay Soni is a financial analyst with more than 5 years of experience in working with stocks, Forex, derivatives, and other assets. As a founder of a boutique research firm and an active researcher, he covers various industries and fields, providing insights backed by statistical data. He is also an educator in the field of finance and technology.
As an author for Traders Union, he contributes his deep analytical insights on various topics, taking into account various aspects.
Dr. BJ Johnson is a PhD in English Language and an editor with over 15 years of experience. He earned his degree in English Language in the U.S and the UK. In 2020, Dr. Johnson joined the Traders Union team. Since then, he has created over 100 exclusive articles and edited over 300 articles of other authors.
The topics he covers include trading signals, cryptocurrencies, Forex brokers, stock brokers, expert advisors, binary options. He has also worked on the ratings of brokers and many other materials.
Dr. BJ Johnson’s motto: It always seems impossible until it’s done. You can do it.
Mirjan Hipolito is a journalist and news editor at Traders Union. She is an expert crypto writer with five years of experience in the financial markets. Her specialties are daily market news, price predictions, and Initial Coin Offerings (ICO). Mirjan is a cryptocurrency and stock trader. This deep understanding of the finance sector allows her to create informative and engaging content that helps readers easily navigate the complexities of the crypto world.