What Are Moving Averages?
Moving averages are commonly used technical indicators that smooth out price to show current market direction and to indicate trend reversals. The trend-following indicator is also known as a lagging indicator, as it’s based on past price movements. By smoothing price action, these sets of indicators filter out noise.
Regardless of which moving average you are using, a rising moving average always shows that prices of underlying assets are generally increasing. Conversely, whenever a moving average is moving down, the price of the security must ultimately be moving down.
Types of Moving Averages
- Simple Moving Average
- Exponential Moving Average
Simple Moving Average
A Simple Moving Average is computed by adding the last X number of closing prices of a given security and then dividing by number Y. For instance, a five-period simple moving average on a one-hour chart refers to the closing price for the last five hours divided by the number five.
While the simplest type of moving averages, Simple Moving Averages are susceptible to noise, which leads to spikes. For this reason, this type of indicator can give false signals.
Exponential Moving Average
The exponential moving average is a trend-following indicator that applies more weight to the most recent price, in calculations. A five-period exponential moving average, when applied on a daily chart, would essentially see prices of the third, fourth, and fifth day given more weight in computations than those of day one and day two.
By giving more weight to the recent price data, the exponential moving average puts more emphasis on what traders are doing at a given moment than what they did in the past.
Exponential vs. Simple Moving Average
A closer look at the chart above, it is clear that the red 30 exponential moving average is closer to the price than the 30 simple moving average. For this reason, the 30EMA accurately represents the most recent price action by placing more emphasis on what is happening at a given time.
Moving Average Lengths
The common moving average lengths for both SMA and EMA are 10, 20, 50, and 200. The lengths applied to a technical analysis chart depend on what a trader wants to achieve. A moving average with a short time frame such as 5 or 10 will always react faster to price changes than an MA with a long lookback period such as 100 or 200.
A 20-day Simple or Exponential Moving Average would be of great benefit to a short-term trader as it would follow price closely, thus providing an accurate trend. A 100-day MA, on the other hand, would be more beneficial to a longer-term trader given the more data points taken into the computation.
Moving Average Trading Strategies
Moving averages have given rise to a number of trading strategies which depend on how the indicators react to price changes on charts. The crossover strategy is one of the most commonly used approaches, as it allows traders to react appropriately when prices move above or below a given moving average.
In the crossover strategy, two types of moving averages with varying periods are generally used. For instance, when using a five- and 15-period moving average, a potential breakout signal would occur whenever the five-period moving average crosses above the 15-period moving average, indicating an uptrend.
Likewise, whenever a five-period MA crosses below the 15-period MA, this could be a signal for a breakdown, signalling that a downtrend is materializing.