Moving averages is a very popular lagging price indicator used by most traders for support and resistances in the trending markets. In this post, we will analyze why we need to use moving averages followed by what are different kinds of moving averages and how traders use these averages for their trading strategies.
What are Moving averages
Moving averages is the average price over a particular length in the selected time frame. Moving averages can be plotted on any time frame the technical trader/investor choses like 1 minute, 5 Minute, 4hours, Daily, weekly or monthly charts. Moving averages are used to smooth out price data by creating a constantly updated average price.
Moving average price is unique for the length considered and selected time frame. For example, 10 ( length) day moving average price in a daily ( time frame) chart will be different from 10 minute moving average price plotted on the 1 minute chart. Also, moving averages are considered a lagging indicator as it is based on past prices.
Typical lengths plotted for moving averages are 10, 20, 50, 100, 200. Having said that, most of the trading platforms give the ability to customize the moving average lengths in the selected time frame. For example, some traders use lengths of 8 and 21 for moving averages
Why moving averages are used
As mentioned above, moving averages represent constantly updated average price for the length considered on a selected time frame and is the most popular indicator used by traders. Traders typically would like to pull the price back to the average price of the length considered in the selected time frame before going up in the same direction as earlier ( continuation pattern). Typically, traders use the moving averages for
Trend Identification: As mentioned earlier, moving averages are mostly plotted for lengths of 10, 20, 50, 100, 200. Also, the most common time frames used by traders for trading with the trend are 4 hour, daily and weeklies. Moving averages 10, 20 and 50 are typically used by swing and day traders who are looking to trade in the range of 4-6 weeks where as 50, 100, 200 are used by traders who are looking to trade in the range of 4-6 months and above.
For traders in the range 4-6 weeks
Moving Average 10: Equity with price above Moving Average 10 is considered to be in short term uptrend in the time frame selected
Moving Average 20: Equities with price below Moving Average 10 but above MA 20 is considered to be in intermediate term uptrend in the time frame selected.
Moving Average 50: Equities with price below moving average 10 and 20 but above moving average 50 is considered to be long term uptrend in the time frame selected.
For traders in the range 4-6 months and above
Moving Average 50: Equity with price above Moving Average 50 is considered to be in short term uptrend in the time frame selected
Moving Average 100: Equities with price below Moving Average 50 but above MA 100 is considered to be in intermediate term uptrend in the time frame selected. Moving average 100 on the daily charts represents 20 weeks of trading and would give a fair idea about the trend of the market.
Moving Average 200: Equities with price below moving average 50 and 100 but above moving average 200 is considered to be long term uptrend in the time frame selected. Moving average 200 on the daily chart represent 40 weeks of trading. It is usually compared to moving average 255 which represents the whole year of trading.
Support and resistance
Moving averages are typically used as either support or resistance for continuation of the trend. Let's see how moving averages can be used effectively as support and resistance with an example. Below, is the TSLA daily chart.
As show in the daily chart above, TSLA broke over Moving average 10 and 20 at the starting point mentioned in the chart and closed above the Moving average 10 every single day indicating a short term bullish trend. Traders would love this kind of set up and may keep moving their stop loss just below Moving average 20 ( pink line) or at the ichimoku baseline. Traders might get out of this trade if it either closes 2 days in a row below moving average 20 or if it touches the ichimoku baseline. This set up can be most often seen in trending markets.
Types of Moving averages
There are 4 types of moving averages available on the chart of most trading platforms.
Simple Moving Average (SMA)
SMA is calculated by summing up the prices of instrument closure over a certain number of single periods
MA = SUM (CLOSE (i), N) / N Where SUM — sum, CLOSE (i) — current period close price;N — number of calculation periods
Exponential Moving Average (EMA)
EMA is calculated by adding a certain share of the current price to the previous value of the moving average. With EMA, latest close prices are of more value. P-percent EMA is computed as follows
EMA = (CLOSE (i) * P) + (EMA (i - 1) * (1 - P))
Where:CLOSE (i) — current period close price; EMA (i - 1) — value of the Moving Average of a preceding period; P — the percentage of using the price value.
The other two types of moving averages are smoothed weighted moving average and Leniar weighted moving averages. But, these averages are rarely used by traders. SMA and EMA are popular. I personally use SMA for my trading strategies.
Trading strategies with Moving Averages
CrossOvers
is a very popular strategy among traders who trade the trend. In general, trend is considered bullish when shorter length moving averages are above the longer length moving averages. For example, an instrument considered is bullish when its moving average 10 is above moving average 20 and moving average 20 is above moving average 50 ( can be extended to 100 and 200). Similarly, trend is bearish when shorter length moving averages are below the longer term averages. For example, an instrument is considered bearish when its moving average 10 is lower than moving average 20 and moving average 20 is lower than moving average 50 ( can be extended to 100 and 200)
Whenever a shorter length moving averages crosses over a longer term moving average, the trend is considered to be turning bullish from bearish. For example, when moving average 10 crosses over moving average 20, the trend is changed from short term bearish to short term bullish. Most of you might have heard about Golden Cross and Death cross. Golden Cross is the term for the bullish trend formed when moving average 50 crosses above moving average 200 for the markets considered (typically SPX or SPY is used). Death Cross is the term for the bearish trend formed when moving average 200 crosses above moving average 50 for the markets considered(typically SPX or SPY is used).
Breakouts
Traders typically look for break outs of the prices above moving averages to ride the trend. A moving average break out is a condition where the price of the instrument rises above the moving average considered and closes above the moving average. It is very critical to ensure that it is not a fake break out ( Price may close below the moving average considered in the next time period) using other indicators such as volume ( is there enough buying pressure for the price to change it s trend ) and oscillators (RSI) etc. The best break out pattern will be when a flat line intersects with the moving average indicating that there are multiple instances when the price bounced of at this level
Summary
I truly believe that moving averages ( either SMA or EMA) can be a vital part of your trading system allowing you to trade with the trend. It is available on all trading platforms and can be customized for any length on the selected time frame. Lot of indicators like Bollinger bands and MACD use moving averages internally.
Breakouts and crossovers are the most popular strategies for staying with the trend and can be monitored or alerted for entering a profitable trade in your trading platform. Moving averages works best when used in conjunction with flat lines and fibonacci and ichimoku based on my trading experience.
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