How To Use Moving Averages
Updated: Feb 5, 2022
A moving average is a simple technical analysis tool used by investors and traders alike to analyse market price trends over time for their chosen asset, be it a stock or cryptocurrency.
Moving averages are primarily used to 'smooth out' turbulence in market price data by creating a constantly updating (i.e. moving) average price.
There are a number of advantages to using a moving average in your trading or investing decision-making, as well as options on what type of moving average to use. Moving average analysis has long-prove a popular technical indicator tool as they can be tailored to any time frame, meaning they can be used to suit both long-term investing and short-term trading strategies. Moving averages are completely customisable; the average price is taken over a specific period of time - maybe 10 days, 20 minutes, 30 weeks or any time period the trader or investor chooses to suit the objectives of their analysis.
Why use Moving Averages?
A moving average helps cut down on the amount of "noise" on a market price chart by smoothing-out the price data turbulence by calculating a trailing moving average over a specific time-period.
Traders and investors analyse the direction of the moving average to get a basic idea of which way the price is trending. Moving averages are a technical indicator, and as such, they provide technical signals with respect to the future price action of a stock or cryptocurrency.
If a stock or crypto is on an upward trajectory, the price trend is seen as bullish overall, and if the current market price of a stock or cryptocurrency is above the moving average, it is taken as a bullish signal for future price movements.
If the moving average is showing a downward trajectory, and the price is moving down overall this is taken as a bearish signal, especially where the current market price is below the moving average. If the moving average is trending sideways, the market price for a stock or crypto is likely in a range and is in a period of consolidation.
A moving average can also act as a support or resistance line when combined with other technical indicators.
In an uptrend, a 50-day, 100-day or 200-day moving average may act as a support level. This is because the moving average acts like a floor (support), so as the market price of an asset approaches the 'floor' set by the moving average, technical traders expect the market price to 'bounce' from the support level.
In a downtrend, a moving average may act as resistance; like a ceiling, the asset's market price approaches the moving average 'ceiling' and technical traders expect the market price to 'bounce' away from the ceiling 'resistance' set by the moving average.
Needless to say, the asset's market price won't always respect the moving average levels in this way. The price may run through support or resistance levels, or stop and reverse prior to breaching it. Whatever happens, when using moving averages to set 'support' and 'resistance' levels, it is key for technical traders to analyse what happens when support and resistance levels are breached, as this acts as a signal that a change in the asset's market price trend may have occurred.
As a general guideline, if the market price is above a moving average, the trend is bullish. If the price is below a moving average, the trend is bearish. However, moving averages can have different time-periods, so one moving average may indicate an uptrend while another moving average indicates a downtrend.
This is why it is important to use a moving average in your technical analysis that supports your investing or trading objectives objectives.
Types of Moving Averages
There are two main types of moving average, differentiated by the method used to calculate the moving average result.
Simple Moving Averages (SMAs)
A five-day SMA adds up the five most recent daily closing prices for an asset and divides it by five to create a new SMA(5) result for each day. Each SMA(5) result is connected to the next, creating the singular SMA(5) line.
A 200-day SMA adds up the two hundred most recent daily closing prices for an asset and divides the result by 200 to generate a new SMA(200) result for each day. Each SMA(200) result is connected to the next, creating the singular SMA(200) line.
Simple moving averages are exactly that - a simple calculation of the average price of an asset at 'close' for a given number of time-periods (usually days).
Exponential Moving Averages (EMAs)
The second most popular type of moving average is the EMA.
The calculation of an EMA is slightly more complex than SMAs, as it applies a greater weighting to the most recent closing prices, where as SMAs apply equal weighting to all closing prices used to calculate the latest result.
The principle is similar between EMAs and SMAs - you are calculating the average market 'closing' price over a number of time-periods. However, the key difference is that greater weighting is placed on the more recent 'closing' prices, making an EMA more 'sensitive' to market price movements than its equivalent SMA would be. For example, if you plot a 50-day SMA and a 50-day EMA on the same chart, you'll notice that the EMA reacts more quickly to price changes than the SMA does, due to the additional weighting on the most recent closing prices.
Charting software and trading platforms worth their salt - including our very own BullsEye app - typically do the calculations for you, so no manual calculations are required. But it is important that you understand the differences between the two and how to interpret changes in both SMAs and EMAs.
One type of moving average isn't better than another. What does matter is that you are able to analyse them to interpret the trading signals they generate. An EMA may work better for a time based on the circumstances, and at other times, an SMA may work better. The time frame chosen for a moving average will also play a significant role in how effective it is (regardless of type).
A quick aside...
Within the BullsEye app we have done the hard work for you.
To help you analyse your current positions and understand the signals given by each type of technical indicator, we provide 'bullish' and 'bearish' signals based on the latest technical results, to help guide your next moves!
Length Really Does Matter!
Common moving average lengths are 10, 20, 50, 100 and 200 days. Which time-period your choose depends on your investing or trading time horizon. The time frame you choose for a moving average, also called the "look back period," can play a big role in how effective it is in relation to your strategy.
A moving average with a short timeframe will react much quicker to price changes than a moving average with a long "look back period".
For example, a 20-day moving average may be of analytical benefit to a shorter-term trader since it follows the price more closely and therefore produces less "lag" than the longer-term moving average, such as a 200-day moving average would. "Lag" is the time it takes for a moving average to signal a potential reversal or change in trend.
The value of a 20-day moving average reacts much more quickly to market price fluctuatioins as there are fewer data points to 'water-down' the recent price increase or decrease. Where as a 200-day moving average may be more beneficial to a longer-term trader who is less interested in short-term price fluctuations, but more interested in the longer-term trend.
Recall that, as a general guideline, when the market price is above a moving average, the trend is considered 'bullish'. So when the price drops below that moving average, it signals a potential reversal based on that moving average. A 20-day moving average will provide many more "reversal" signals than a 200-day moving average.
A moving average can be any length. Adjusting the moving average length so it provides more accurate signals based on your investing or trading strategy will also help create better future technical signals.
Moving Average "Crossovers"
Crossovers are one of the main trading signals considered when analysing moving averages.
The first and simplest crossover type is the 'price crossover', which is when the market price of a stock or crypto crosses above or below its moving average to signal a potential change in trend.
Another strategy is to apply two moving averages to a chart: one longer in length and one shorter. When the shorter-term moving average crosses above the longer-term moving average, it is interpreted as a 'buy signal', as it indicates that the trend is 'bullish'. This is known as a "golden cross."
Meanwhile, if the shorter-term moving average crosses below the longer-term moving average, it is interpreted as a 'sell signal', as it indicates that the trend is 'bearish'. This is known as a "death cross".
Key considerations when using moving averages
As we've outlined, moving averages are calculated based on historical data, and nothing about the calculation is predictive in nature. There are simply no guarantees!
Therefore, the outcome of analysing moving averages to decide your next trading or investing decision are not fool-proof. At times, the market seems to respect moving average support and resistance levels and trading signals, and at other times, it shows these indicators no respect whatsoever.
One major problem with moving averages is that, if the price action becomes choppy, the price may swing back and forth violently, generating multiple trend reversal or trading signals in a short space of time. When this occurs, it is best to step aside or utilise another technical indicators to help clarify the trend. The same thing can occur with moving average crossovers when the moving averages get "tangled up" for a period of time, triggering multiple signals, leading to confusion as to the overall signal.
Moving averages work quite well in strong trending conditions but poorly in choppy or ranging conditions. Adjusting the time frame can remedy this problem temporarily, although at some point, these issues are likely to occur regardless of the time frame chosen for the moving average(s).
Take Home Message
A moving average simplifies the analysis of market price data by 'smoothing it out' and creating one flowing line. This single moving average line makes visualising the trend easier.
Exponential Moving Averages react quicker to price changes than Simple Moving Averages. In some cases, this may be good, and in others, it may cause false signals. Moving averages with a shorter look back periods will also respond quicker to market price turbulence than a moving average with a longer look back period. Configuring your moving averages based on your trading or investing strategy and overall time horizon is key!
Moving average crossovers are a popular strategy for identifying both buy and sell signals. Moving averages can also be used to highlight areas of potential support or resistance, and identify trading ranges. While this all may appear predictive and straight-forward, moving averages are always based on historical data and simply show the average price over a certain time period and, if to be used, should be done so in combination with other technical indicators.