What are moving averages?
Moving Averages are commonly used technical indicators that smooth out price to show current market direction as well as indicate trend reversals. The trend-following indicator is also known as a lagging indicator as it is 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 would always show that prices of underlying assets are generally increasing. Conversely, whenever a moving average is moving down, then the price of security must ultimately be moving down.
Types of Moving Averages
- Simple Moving Average
- Exponential Moving Average
Simple Moving Average
A Simple Moving average computed by adding the last X periods closing prices of a given security and then dividing by number X. 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 number 5.
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 on placing more emphasis on what is happening at a given time.
Moving Average Lengths
The common moving average length 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 look back 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 provide 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 Averages Trading Strategies
Moving averages have given rise to a number of trading strategies which depend how the indicators react to price changes on charts. The crossover strategy is one of the commonly used, as it allows traders to react appropriately when prices move up 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 MA, indicating an uptrend.
Likewise, whenever a five period MA crosses below the 15-period MA, then this could be a signal for a breakdown signalling a downtrend is materializing.