Moving Averages

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The Moving Average is a line which represents the average price over a specific time frame. It smooths out price data by constantly updating these averages. There are different types of moving averages, which we shall cover later, however, they are almost always used to identify trends on charts.

Moving averages, like most indicators, help to reduce "noise" in the market. By looking at the direction in which the moving average is going (up or down) you get an indication of the overall direction of the market.

Some of the most common periods used for moving averages are the 10, 20, 50, 100 & 200. These are often referred to as the "X day moving average" however, a more accurate description would be "X bar moving average" or "X candlestick moving average" as they can, and most certainly are, used on multiple time frames. 

The lower the period - the closer the line follows the actual price. Therefore, the higher the period - the less noise generated. Lower periods are likely to be more beneficial to short term traders as they do not "lag" behind the market as much as higher period moving averages. For example, if price spikes higher over 3 candles, the 10 bar moving average will follow it closely because 3 candles represents 30% of the group in which is being averaged. However, the 200 bar moving average will barely change because 3 bars only represents 1.5% of that group.

As stated above, moving averages are used to identify trends. A general rule of thumb is that - if price is below the moving average the market is in a downtrend. If price is above the moving average the market is in an uptrend. Ultimately, this will vary depending on the period you chose to use. Hence why shorter term traders benefit most from shorter periods as a 10 bar moving average will produce more reversal signals than the 200 bar moving average.

Types of Moving Averages:

There are three common types of moving averages - Simple Moving Average (SMA), Weighted Moving Average (WMA) & Exponential Moving Average (EMA).

A Simple Moving Average (SMA) adds up the previous candle's closing prices throughout a specific period and divides this by the number of candles within that period. Therefore, the 20 SMA adds up the closing prices of the previous 20 candles and divides this total by 20. This calculation is continuously carried out by the charting platform in the background and will continue to plot the SMA for the previous 20 candles and time moves on. 

A Weighted Moving Average (WMA) gives an average of the last prices through a specific period of time, where the weighting of the average decreases with each previous price. The calculation is as follows: 

WMA = (price * weighting factor) + (previous price * weighting factor - 1) 

You can weight the moving average based on the specified period but the total should add up to 100%. For example, if you were to calculate the WMA of the last 3 candles (3 WMA) you could weight the most recent candle 50%, the previous candle 30% and the first/oldest candle 20%. 

Assume the prices are 100, 95 & 90 where 90 is the most recent. The calculation would be:

((90 * (50/100)) + (95 * (30/100)) + (100 * (20/100))) = 45 + 28.5 + 20 = 93.5

This calculation clearly shows that the average is weighted towards the most recent price of 90. 

The WMA works well if you want to customise the moving averages. It also enables you to weight it towards historic prices rather than most recent prices. Other moving averages don't allow for this.

An Exponential Moving Average (EMA) gives the average of the last prices through a specific period of time, where the weighting of the average decreases exponentially with each previous price/period. Therefore, recent prices have a higher weighting than past prices.  

I'm not going to to bother inserting the calculation as the charting platforms do all of the calculations for you. Also, I don't think it will help further explain the EMA whereas I feel the WMA calculation does assist with it's understanding. The EMA calculation is somewhat similar to the WMA.

The EMA reacts more quickly to price changes than the SMA meaning, if the price were to move sharply in one direction, the EMA would react more violently than the SMA. 

I personally use the EMA 99% of the time I incorporate a moving average into my trading.

Use cases:

There are several ways to trade using moving averages. I will only cover a few of these for the purpose of this article however, you can take these examples away and tailor them to your style of trading. 

2x Moving Averages:

Firstly, having two or more moving averages on the chart at any one time, each of different periods, can introduce another filter to your trend identification technique. When the shorter period moving average crosses above the longer period, it is a buy signal, indicating a bullish trend. The opposite is true if the shorter term moving average moves below the longer term moving average. Not only do you have the confirmation of the price action happening above the moving average, but you also have a lower period moving average above the higher period moving average. This indicates that the recent price action is moving higher when compared to the longer term historic price action. 

When a short period moving average crosses above the longer period moving average, this is often referred to as the "golden cross" - indicating a buy signal. When it crosses below the longer period moving average, this is often referred to as the "death cross" - indicating a sell signal. Most commonly, the 50 and 200 moving averages are used to determine these buy and sell signals.

Support & Resistance

Moving averages can be used as areas of support and resistance. In this instance a trader might buy when the price moves down to touch the top of the moving average and sell when prices moves up to touch to bottom of the moving average. 

This might be coupled with the previous strategy whereby, two moving averages are applied to the chart. When the lower period moving average is above the higher period moving average a trader might wait for price to move down and touch the lower period moving average and enter a long position. Not only has a bullish trend been identified but you now also have a "zone" for entering the trade. 

In my personal opinion, a trade should only be entered based on certain candlestick formations at the touch of the moving average (see candlestick analysis tab). However, any trading plan should undergo relentless back testing before it is applied to live trading and therefore, your results might show that a simple touch of the moving average works well as a reason for entry.