- Using moving averages to see the bigger trend amid temporary price moves
- Using moving averages to confirm a trend or trend reversal
- How successful traders use moving averages to make trading decisions
Averaging prices over time can help filter out the noise and see the overall trend
Price charts typically show a lot of variation that makes it harder to tell what the trend is. A moving average plots the average of those prices over a period of time, smoothing out those variations and giving you a line that shows the overall direction.
Different moving averages give different weight to the price data
Moving averages vary in how they are calculated, but are used in the same basic way. Some give equal weight to each price point, while others place more importance on recent data. The three most common types of moving averages are simple, linear, and exponential.
Simple Moving Average (SMA)
The most common moving average takes the sum of the past closing prices over the time period and divides by the number of prices. A 10-day moving average adds the last 10 closing prices and divides by 10. A longer time period like 200 days will be smoother and straighter and gives a better idea of the long-term trend as well as when it might reverse.
Because in an SMA older prices have the same impact on the result as newer ones, traders also use moving averages that give more weight to recent prices.
Linear Weighted Average
The less common linear weighted moving average takes the sum of all the closing prices over a certain time period, multiplies them by the position of the data point, and then divides by the sum of the number of periods. A 10-day linear weighted average would multiply today's closing price by ten, yesterday's by nine, and so on. Those numbers then get added together and divided by the sum of the multipliers (10+9+8…+1).
Exponential Moving Average (EMA)
The exponential moving average also gives more weight to recent data and responds to price changes faster than a simple moving average. It is generally considered more efficient than the linear weighted average.
Most charting packages for stocks, futures, and forex will display simple and exponential moving averages and sometimes others. The Nadex platform shows the SMA and EMA and allows you to adjust their parameters to your liking.
How traders use moving averages
Moving averages can help identify trends and trend reversals as well as provide support and resistance levels at which to place entry and exit orders.
Trends are easier to confirm when the price bars move in the same direction as their moving average. When a moving average is heading upward and the price stays consistently above it, the market is in an uptrend. A downtrend has a downward sloping moving average with the price staying below it.
You can also compare two moving averages of different time frames. If the short-term average is above a longer-term average, the trend is up. If the short-term MA is below, it’s most likely a downtrend. We say “most likely” because you should see it happening over a significant period. A quick cross from above to below doesn’t automatically signal a trend reversal.
Many, many traders have learned this the hard way by pulling the trigger in anticipation of a trend reversal that never materialized.
Moving average crossovers
When the price itself crosses the moving average it can signal that the trend is about to end or at least pause for a while. Long term investors, for example, often consider it a bearish sign when stocks drop below the 50- or 200-day moving average. When prices stop doing what they have been doing for months, that is a strong sign that something new is happening.
Some traders plot two or more moving averages of different time periods and look for places where the two lines cross. Trading moving average crossovers is a common technical trading strategy. The key to using this strategy successfully is to look for other factors, like higher highs and higher lows to signal an uptrend, before entering. A moving average crossover by itself is not enough and can often be a false signal.
How can a crossover be a false signal? Sometimes an uptrend will include two or three periods of sharp downward correction. If the price falls a large distance, it may be enough to skew the averages temporarily. While smart traders will see it for what it is, a temporary correction in a larger trend, less skillful traders will jump the gun and act on the signal, only to watch the market resume the prevailing trend.
Support and resistance
Traders can also use moving averages as support and resistance levels. A common, basic method used by stock investors is to watch for the price to break below or bounce off the 200-day moving average.
Because so many traders are watching that same line and planning similar ways to use it, it becomes a kind of collective meeting place. The market as a whole agrees that if and when they want to vote, so to speak, on whether the market should reverse trend and head in the opposite direction, they’ll meet and hold that vote at the 200-day moving average line.
That line isn’t the only such decision-making point. Fibonacci levels and trendlines connecting successive highs and lows play the same role. If the market breaks through those lines with strong momentum, there’s a stronger possibility that it will continue in the new direction.
Because so many traders use them for support and resistance, moving average lines also make good places to set stop-loss orders. If you sell a binary option, for example, then see the underlying market go above a significant moving average line and stay above it, you might decide to exit the trade early because it no longer meets your criteria for a downtrend.
That may be the wisest use of moving averages and moving average crossovers. Instead of using them blindly as a red light/green light “system,” instead of believing that they can reveal some secret to you that other traders can’t see, you can use them as reminders to check whether the trade still meets your criteria and fits your trading plan. You can use them as places to make decisions and retain control of the trade.
- How moving averages help filter out the noise from individual price moves
- How moving averages can help confirm a trend or possible trend reversal
- How traders use moving averages to make trading decisions
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