The Moving Average: Definition & Strategies

Dec 12, 2022 Written By LAT Staff

Technical traders often begin their price study using moving averages. It acts as a standalone or comparative measure to other indicators and is typically one of the first indications traders include in their charts. Consider it an attempt to decrease noise to represent a stock's movement somewhat more clearly.

As a trading strategy, the moving average is often used for short-term transactions to capitalise on market changes. Calculating prices and their moving averages may be done using either the intraday high and low or the closing price. Moving averages commonly identify market entry opportunities and support and resistance levels. The moving average often serves as a level of resistance when the price is trading below it and as a level of support when the price is trading above it.

How Moving Averages Work

The moving average is the average futures contract or stock price over a certain period. Moving average (MA) is an easy technique for doing technical analysis that smoothes out price data by computing a continuously updated price average. A single chart may have a single moving average or many time periods.

Since moving averages represent the average closing price over a certain period, the moving average helps traders readily identify the general trend of the market. When the price goes below or above a moving average line, traders may use this as a signal that the price may halt or retrace at that time.

The basic purpose of the moving average is to lessen short-term market fluctuations. Numerous traders use multiple Moving Averages simultaneously, giving a more thorough market picture. The average is computed over a specified time period, such as 10 days, 20 minutes, 30 weeks, or any other time period selected by the trader. There are advantages to using a moving average in trading, as well as options for the kind of moving average to use.

Overall, the moving average helps to reduce the amount of chart noise. Consider the direction of the moving average to acquire a basic understanding of the price movement. If it is tilted upward, the price increases on average; if it is tilted downward, the price drops on average; and if it is moving horizontally, the price is likely in a trading range.

Types of Moving Averages

The three most common types are simple, exponential, and weighted. All three averages indicate whether the most recent transaction's price has crossed below or above the moving average and may serve as a buy or sell signal. Moving averages examine both short-term and long-term trends and minimise volatility. Furthermore, the MA is a customisable indicator, enabling the trader to choose the time period that most closely aligns with their trading objectives.

Simple Moving Average

The simple moving average (SMA recalculates the average price over a certain number of days each day. When the new trading day starts, the last price in the preceding data set is replaced with the latest, culminating in a "moving" average as trading days pass.

Weighted Moving Average

Akin to the exponential moving average, the weighted moving average emphasises current prices above historical data over a set period of time but assigns a weight to recent prices. Consequently, the weighted moving average is often more precise than the standard moving average, which weighs all values equally.

Exponential Moving Average

In the exponential moving average (EMA) formulation, a weighting variable lends more weight to current price data and less weight to older price data. This makes them more susceptible to price swings and also helps to level the line. As the initial datapoint of the EMA, the SMA of a certain day is used. The EMA approach utilises a weighting factor or smoothing constant that is proportional to the number of days in the moving average.

Exponential moving averages calculate the average of a series of variables using a weighting multiplier that ordinarily gives more weight to more recent data. EMAs are calculable in three phases.

Selecting the Appropriate Moving Average for your Requirements

Examine the many moving averages on a chart if you are a newbie investor. If you wish to participate in occasional trading, choose a moving average time period that gives these kinds of signals. You can determine the optimal time period by including four or five moving averages in your chart.

Calculating the Simple Moving Average

Examine the following computations for a simple moving average:

  • Determine the time frame you want to analyse - Selecting the time period from which to collect data is the first stage in computing the simple moving average of a commodity. For example, the needed duration may be five days, fifty days, one hundred days, or two hundred days.
  • Evaluate the highest prices throughout each period - Suppose you intend to gather price data for seven days. This means that you assess stock prices for a commodity every day and select the highest price point for that period (one day). To compute the seven-day simple moving average, you must watch stock prices every day and record the highest price point for the remaining six days.
  • Totalise the sum of each price - When the highest stock prices for a specific commodity throughout a defined time period have been identified, each price point must be summed.
  • Divide the sum by the number of predetermined time intervals - After adding each price point and finding the answer, divide the total by the number of recorded time periods.

Advantage of Using the Moving Average

Straightforward Indicator - Perhaps the greatest advantage of using moving averages in trading is that they are a straightforward indicator. A moving average line on a chart immediately reveals a security's price's direction. By integrating different moving average periods, it is possible to establish the trend's strength. If the moving average of security is sloping higher, it indicates that the price is rising.

Convincing Trend Analysis - Moving averages provide a simple approach for eliminating market noise, making them the perfect instrument for trend analysis. Even two moving averages may be used to confirm trend shifts.

Assisting with Entry Points - In addition, it is crucial to understand that moving averages are a good indicator for choosing entry positions in trading. Many traders struggle to identify the ideal entry point for a trade with a favourable risk-to-reward ratio. Moving averages may aid in selecting an advantageous entry point.

Providing further price insight - Technical indicators may provide a piece of the price movement puzzle, especially for investors closely following a firm.

Removing Noise - This indicator allows investors to focus on longer-term trends rather than day-to-day fluctuations by considering extensive time periods. • They may be beneficial during market turbulence.

Exploring Moving Average Trading Techniques?

Multiple moving averages often facilitate a more effective trading technique. Multiple moving averages are used in the three instances of multiple moving average trading methods shown below.

Trend Trading

Usually, a heavily trending market will exhibit some degree of order in regard to moving averages. The price should trade below the short-term SMA, followed by the medium-term and long-term averages in a market with an upward trend. This would be the opposite of a downward trend. When a market exhibits this kind of ordered feature, a trend-following market trading approach is possible. Buying (uptrend) or selling (downtrend) at the closest moving average would help traders locate entry opportunities inside this market with a strong trend.

Golden and Death Cross

A shorter-term SMA crossing above a longer-term SMA to produce a buy or sell signal is one of the most often utilised trading methods. In the 50-day and 200-day moving averages scenarios, the death cross and golden cross represent one such technique. The bearish form occurs when the 50-day SMA falls below the 200-day SMA, signalling a sale. In contrast, a bullish signal is generated when the 50-day SMA surpasses the 200-day SMA.

Bollinger Bands

This technique employs the Bollinger band instrument with the 20-day SMA positioned in the centre of the bands. This strategy may be used without Bollinger bands; however, employing the bands gives extra advantages. Even when a market is heavily trending, the price will typically revert to the mean prior to pushing back in the direction of the trend, according to this theory. As a result, the middle Bollinger band (the 20-day SMA) is often used as support or resistance, making it a valuable trading tool.

Bottom Line

Using the moving average to smooth the trend is a simple approach to maintain a strategy for a trader who wishes to enter and exit a stock during pullbacks while remaining in a rising trend. Recognising a shift in the direction of the moving average is a strong indicator that what has been working is about to lose its effectiveness and may herald the end of a trend.

Although you invest in a relatively safe way with dollar-cost averaging, you still have no guarantee of a positive return. That’s why you should always remember that you can also lose your investment and never invest with money you can’t afford to lose.

Next Steps

Start developing your profitable trading strategy through a combination of fundamental analysis and technical analysis by enrolling on one of our award winning, accredited trading courses.

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