Using moving averages for trading. A moving average is a technical indicator that helps smooth out price action by filtering out the noise from random price fluctuations. It is created by taking the average of a security’s price over a specified period, which can be anywhere from one day to 10 years. Moving averages commonly identify trends, momentum, and support and resistance levels.
There are different moving averages, but the most common are simple moving averages (SMAs) and exponential moving averages (EMAs). SMAs give equal weight to each price in the period; EMAs give more weight to recent prices.
Traders often using moving averages for trading to generate buy and sell signals. A buy signal occurs when the short-term moving average crosses above the long-term moving average; a sell signal occurs when the short-term moving average crosses below the long-term moving average.
Another popular way to using moving averages for trading is to generate trading signals based on crossovers when the price of a security moves from one side of a moving average to the other. A bullish crossover occurs when the price moves from below to above the moving average; a bearish crossover occurs when the price moves from above to below the moving average.
Crossovers can be used as either leading or lagging indicators. A leading indicator generates signals before a trend changes; a lagging indicator generates signals after a change in trend has occurred. For example, the most common using moving averages for trading, the crossover is the 50-day/200-day crossover, which signals a change in trend from bearish to bullish or vice versa.
Moving averages can also identify areas of potential support and resistance. A support level is an area where the price has historically found difficulty falling below; a resistance level is an area where the price has historically found it difficult to move above. These levels can be created by plotting the moving averages on a chart and observing where the price action tends to respect them.
The most important thing to remember when using moving averages is that they are a lagging indicator, which means they will only confirm what has already happened. Therefore, they should not be used as a standalone trading strategy but as a tool to help you make better-informed trading decisions.
Types of Moving Averages
Simple Moving Average (SMA)
The simple using moving averages for trading is the most common type of moving average. It is calculated by taking the average of a security’s price over a specified period. The period can be any length, but the most common are 10, 20, 50, and 200 days. SMAs identify trends, momentum, and support and resistance levels.
Exponential Moving Average (EMA)
The exponential moving average is a moving average that gives more weight to recent prices. It is calculated by taking the exponentially weighted moving average of a security’s price over a specified period. The period can be any length, but the most common are 10, 20, 50, and 200 days. EMAs are used to identify trends and momentum and support and resistance levels.
50-Day/200-Day Moving Average Crossover
The 50-day/200-day moving average crossover is a common signal used by traders to indicate a change in trend. It is calculated by taking the 50-day moving average of a security’s price and comparing it to the 200-day moving average. A bullish crossover occurs when the 50-day moving average moves above the 200-day moving average; a bearish crossover occurs when the 50-day moving average moves below the 200-day moving average. In addition, this signal is often used to confirm other technical indicators, such as support and resistance levels or Elliott Wave patterns.
How to Use Moving Averages
There are two main ways to using moving averages for trading: a trend-following indicator or a momentum indicator.
Trend Following Indicator
As a trend-following indicator, moving averages can identify the market’s direction. They do this by taking the average prices over a certain period and plotting it on a chart. The most common periods are 10, 20, 50, and 200 days. If the price is above the moving average, it indicates that the market is in an uptrend; if the price is below the moving average, it indicates that the market is in a downtrend.
Momentum Indicator
As a momentum indicator, moving averages can be used to identify the strength of the market. They do this by taking the difference between the current price and the moving average over a certain period and plotting it on a chart. The most common periods are 10, 20, 50, and 200 days. If the line is moving up, it indicates that the market is becoming more bullish; if the line is moving down, it indicates that the market is becoming more bearish.
Support and Resistance Levels
Using moving averages for trading can also identify areas of potential support and resistance. A support level is an area where the price has historically found difficulty falling below; a resistance level is an area where the price has historically found it difficult to move above. These levels can be used to place stop-loss orders or take profit orders.
The Bottom Line
Moving averages are useful for traders, but it is important to remember that they are a lagging indicator. Therefore, they should not be used as a standalone trading strategy but as a tool to help you make better-informed trading decisions.
