Moving average

Quick definition

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Updated: Jan 10, 2024

A moving average (MA) is a widely used technical analysis tool that smoothens out price data to create a constantly updated average price.

Key details

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  • Moving averages are technical indicators that show the price of an asset represented by a ‘smooth’ line. 
  • There are three types of moving averages: Simple, exponential, and weighted. 
  • Moving averages can help identify trends and reversals.

What is a moving average?

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A moving average (MA) is a widely used technical analysis tool that smoothens out price data to create a constantly updated average price. It is similar to a ‘wave’ that smoothes the chopper waters of daily price changes. Moving averages are used by traders to identify the direction of a trend and find potential support and resistance levels.

The main types of moving average

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There are four main types of moving averages: Simple, Exponential, Weighted and the MACD. Each MA shows a smooth line representing recent price action, although are calculated in a slightly different manner. Here’s an explanation of each:

Simple moving average (SMA)

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  • What it is. The SMA is the simplest form of a moving average. It calculates the average price of an asset over a specific number of periods equally.
  • How it’s calculated.  The closing prices for an asset are added up and divided by the specific period number. 
  • How to use it. Traders often use the SMA to identify the general direction of the trend. If the price is above the SMA, it might be considered an uptrend, and vice versa.

Exponential moving average (EMA)

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  • What it is. The EMA gives more weight to the most recent prices, making it more responsive to price changes than the SMA.
  • How it’s calculated. It uses a formula that gives more weight to the latest prices. The exact calculation involves a bit of math, but thankfully, most charting platforms do this automatically.
  • How to use it. Due to its responsiveness, traders use the EMA for shorter-term analysis. When the price crosses above the EMA, it might signal a potential uptrend, and when it crosses below, a potential downtrend.

Weighted moving average (WMA)

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  • What it is. The WMA assigns weights to each price, with the most recent prices assigned the highest weights.
  • How it’s calculated. Like the EMA, it’s a bit math-intensive, but the idea is to give more importance to recent data points.
  • How to use it. While less common than the SMA and EMA, some traders believe the WMA provides a clearer picture of the current market conditions due to its focus on recent prices.

Moving average convergence divergence (MACD)

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The moving average convergence-divergence indicator (MACD) is a popular momentum indicator that technical analysts use to identify whether a market is trending up or down. The indicator shows the relationship between two moving averages used in price action analysis. 

MACD uses three numbers for its settings. The first is the number used to calculate the faster-moving average. The second represents a number used to calculate the slower moving average. The third is the number that calculates the difference between the faster and slower moving averages.

What are moving averages used for?

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Moving averages can be used to identify trends and find reversals. Here’s a quick look at the various uses moving averages provide.

Trend identification

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One of the primary reasons traders employ MAs is to identify the general direction of a trend. By smoothing out price data, MAs help filter out the noise and highlight the underlying trend, whether it’s upward (bullish), downward (bearish), or sideways (range-bound).

Recognising the predominant trend allows traders to align their strategies with the market sentiment. For instance, in a strong uptrend, traders might focus on buying opportunities or holding onto long positions.

Support and resistance levels

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Moving averages, especially longer-term ones like the 50-day or 200-day SMA, can act as dynamic support or resistance levels. When an asset’s price approaches a moving average from above and bounces off, that MA is acting as a support. Conversely, when the price approaches from below and retreats, the MA acts as resistance.

Crossovers and trading signals

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One of the most popular trading strategies involving MAs is the crossover method. When a shorter-term MA (like the 50-day EMA) crosses above a longer-term MA (e.g., 200-day EMA), it’s often interpreted as a bullish signal or a potential buying opportunity. Conversely, when the shorter MA crosses below the longer MA, it’s seen as a bearish signal or a potential selling opportunity.

How to use moving averages

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There are lots of ways you can incorporate a moving average into your trading or investing strategy, and below are a few explanations of the main ways.

Moving averages for trend analysis

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Moving averages provide valuable information on the direction in which a market is moving. If the MA is angled up, then the underlying price would always be trending in an uptrend.

When angled down, that implies price is moving down. Conversely, when the moving average is moving sideways, then the price is likely to be in a range.

In the chart above, it is clear that a trader would be looking for buy opportunities whenever the 10EMA is above the 20EMA, as the short-term EMA follows price closely. Likewise, whenever the 10EMA is below the 20EMA, then the trend is downwards, signalling the best time to look for sell opportunities.

The moving average for support and resistance

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In addition to indicating the direction that the price is moving, moving averages can also act as support and resistance levels. Whenever price bounces off a moving average, then it can be interpreted as a support or resistance level depending on the direction of flow.

For instance, the chart below shows price rallying higher upon touching the moving average, which appears to be a support level.

As you can see in the image above, the price continues to trend up as the moving average edges higher. Conversely, whenever the price is moving down, the moving average will also start to move downwards.

Moving averages for overextended markets

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Moving averages are also ideal indicators for identifying overextended markets, which could either be overbought or oversold. While trading, it is important to avoid buying or selling securities that are overbought or oversold.

As seen in the chart above, a price is considered overbought or oversold whenever it’s far off the short-term moving average. For instance, in the chart above, the price extended below the 10EMA, triggering an oversold situation.

In this case, it’s important to wait for the market to normalise and come back close to the moving average to consider an entry position.

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Prash Raval
Financial Writer
Prash is a financial writer for Invezz covering FX, the stock market and investing. For over a decade he has traded spot FX full time while... read more.