Understanding Moving Averages
How moving averages can help to improve your trading profits
A fine understanding of moving averages allows traders to analyze prices and market trends. Generally, the moving average is the first indicator that traders add to their charts to measure itself or in comparison to other financial and technical indicators. Since calculating moving averages is not difficult, they are easily plotted. They serve as powerful visual tools for trend-spotting.
Finding a decent understanding of moving averages is important since it is a good indicator used to follow market momentum. If you find yourself unable to understand certain financial and technical terms commonly used in trading, we've got your back. Here, you'll find everything you need to know about moving averages.
What Are Moving Averages?
Averages are taught in school. We all know the statistical and mathematical relevance of averages. Understanding moving averages is just as simple as they are only an extension of averages. They are trend indicators that are commonly used in market and price analysis for their effectiveness and simplicity.
In technical analysis, moving averages are used as indicators representing the average closing price of specific markets over a specific period. They are great indicators to understand the current momentum of the specific market. A moving average is the price average of a market's stock or contracts over a certain period.
There are two types of moving averages - simple moving average and exponential moving average. Both types have different properties. They will both be discussed in the later sections.
Application of Moving Averages
Trade indicators commonly use them for price analysis. A moving average is crucial to technical traders because this simple indicator serves to create the foundation of many other indicators. Technical indicators such as Moving Average Convergence Divergence (MACD) are solely dependent on moving averages.
A moving average functions by smoothening out the market price by forming an average of price fluctuations. This fluctuation is set into a single line that pulsates with all the fluctuating market prices. The calculation of the moving average of stock creates a constantly updated average price, which allows us to smooth out the price data. Calculating the moving average mitigates the effects of random and short-term price fluctuation of stock.
Accurately calculating future conditions of the market is no possible. However, using technical analysis tools such as moving average can help make predictions according to what the past looked like.
Trend Following and Sensitivity of Moving Averages
Moving averages also help identify the trend direction of a market, which aids in determining its support and resistance levels. Therefore, it is a technical trend-following indicator that is based on past trends.
The lag - or trend following - of a moving average is dependent on the period of calculation. This means that a 100-day moving average will be much more lagging than a 15-day moving average. This is because the 100-day moving average comprises prices for a much longer period.
The level at which moving averages can be customized knows no limit. Investors can use any number of days or any stocking agent to calculate moving averages. This gives a personal touch to each moving average calculation, analysis, and understanding.
The most common time stamps at which moving averages are calculated are 15 days, 20 days, 30 days, 50 days, 100 days, and 200 days. Each trader chooses the time frame that they want to work with according to the average sensitivity that they prefer to notice.
Most traders, however, prefer to use 50-day or 200-days moving average figures. They are considered to be two of the most important trading signals in the investing world.
As mentioned earlier, the longer the tie period of calculation, the more the lag of the moving average will be. Therefore, a shorter time period based on moving averages is much more sensitive to market changes. This is because they consist of less information about past trends, which makes them sensitive to the slightest change in the market.
Types of Moving Averages
Now that we have understood what a moving average is, the way it is used, and the trend following the nature of the tool, let us look into the different types of moving averages. There are two types of moving averages - Simple moving average and exponential moving average.
Simple Moving Average (SMA) Explained
A simple moving average, as the name suggests, is the simplest form of moving average. Simple Moving Average (SMA) is calculated by means of calculating the arithmetic mean of the given set of the market value set.
In the case of financial scenarios, a given set of prices is considered to calculate the simple moving average. The different prices are added together before dividing by the total number of prices in that specific set.
This moving average is calculated by adding prices of recent value and then dividing the sum by the number of time periods when the price had fluctuated.
Calculation of Simple Moving Average
In arithmetic terms, the simple formula of calculating the simple moving average of a set of prices is as follows.
SMA = (Price 1 + Price 2 + Price 3 + ………… + Price n) / n
Where SMA is Simple Moving Average, and n is the number of price points.
A simple moving average is the basic average price of a certain commodity in a certain market over a specified period of time.
Let's take the example of a technical trader plot a 15-day simple moving average on a chart of financial values. They will first have to add the previous 15 closing prices of the product. After doing that, they will have to divide the sum by 15 (number of price points) to successfully calculate the simple moving average.
All the various price points are joined together in a line on the graph to form a moving average chart. This creates a visual representation of market momentum and gives a rough idea of how conditions are going to be in the future. This line chart, however, helps in predicting only things that can be foreseen.
Application of Simple Moving Average
The most popular and widely used purpose of calculating a simple moving average is that it is used in technical analysis. A simple moving average helps in quickly identifying if a price trend is upwards or downwards. This gives significant information about where it is safe to invest and where it isn't.
Another analytical use of a simple moving average is a little complex. Two simple moving averages from different time frames are compared with one another. In this case, if the higher simple moving average is the one which is of a shorter duration, an uptrend is expected in the market. However, if the long-term simple moving average is higher, a downtrend is expected in the market.
Shortcomings of Simple Moving Average
In case of longer duration simple moving averages, the problem is that it relies too much on older data. When calculating a 200-day simple moving average, the fluctuation that happened about 198 days back makes a difference in the way future market conditions are perceived to be.
The reliance on historical data might make significant changes to the market predictions. Many economists and traders believe that the current market prices reflect market conditions efficiently. Therefore, considering old data seems like a redundant thing to do.
Exponential Moving Average (EMA) Explained
In order to overcome the shortcomings of the Simple Moving average, an exponential moving average is also considered. While simple moving average focuses on the generation of charts according to historical data, exponential moving average focuses on recent data.
The exponential moving average solely focuses on recent prices in order to make it more responsive to new market information. It is preferred by some traders who like more concise data planning.
Unlike the simple moving average, exponential moving average possesses factors that give multiplicative weightage to recent data points rather than old data points.
An exponential moving average is much more responsive and quicker at fluctuating with price action. This is another reason why it is preferred by certain traders. An exponential moving average allows for early signaling relative to the simple moving average.
Exponential moving average, just like the simple moving average, is plotted commonly by traders for months and years on end. They can also be calculated in periods of 50, 100, and 200 for great marketing analysis. Short-term periods such as 12 and 26 days are also common due to the MACD indicator.
Calculation of Exponential Moving Average
An exponential moving average is a technical indicator which produces sell and buy signals with the help of divergences and crossovers from historical data. Since it differs significantly from the simple moving average, the calculation formula is different too. The formula for the exponential moving average is as follows.
EMAtoday = [Valuetoday x (smoothing/1 + number of days)] + EMAyesterday x [1- (smoothing/1 + days)]
Where EMA is Exponential Moving Average
The most popular choice for the smoothing factor is 2. This helps in calculating the average while giving the most weightage to recent observations. The higher the smoothing factor, the larger influence do recent observations have on exponential moving average.
Application of Exponential Moving Average
The exponential moving average tool is used to identify the various dominant trends in the market in question. This moving average style also helps you find the support and resistance that can be prevalent in the market.
Since EMA is a universal strategy that can be used in trading in all markets, it is used to determine stocks, forex, currencies, indices, and bitcoin values. It is a truly versatile economic indicator.
The exponential moving average has gained popularity among rapidly shifting traders. Since these traders quickly trade in and out of positions, they require a more accurate and sensitive analytical indicator than the simple moving average. This very reason has also gained exponential moving average popularity in volatile markets.
Simple vs. Exponential Moving Averages
There are not many significant differences between simple moving averages and exponential moving averages. However, the difference between the two is substantial. The results and predictions that come out of each are so different that it is necessary for serious traders to use both types in order to figure out the most accurate market future.
The major difference between the simple moving average and exponential moving average lies in their sensitivity. The sensitivity that each moving average type shows is so different that it makes a huge difference in market analysis.
While an exponential moving average gives higher weightage to recent prices, a simple moving average gives equal weightage to all market values. This makes simple moving average time-bound sensitive, while the exponential moving average is more sensitive. EMA is extremely sensitive to recent prices, while SMA is sensitive to trends.
Since both the moving averages are used in a similar manner, and both are interpreted in the same way, the differences are few. They are both used by technical traders to make sure that they have a smoothened visual representation of market prices.
Many new economists and traders believe that the recent trends, in fact, the current market price that is enough to determine market momentum. Therefore, EMA has gained more popularity over recent years for its recent accuracy.
Different Market Trends That Are Observed with Moving Averages
A trend is a simple direction that the market is following. This means that the general direction of the price of commodities shows what trend is followed in the market. Given below are the two price directions, i.e., the two economic trends followed in the market.
An uptrend allows traders to buy stocks at low prices and sell them at high prices. This helps in continuous profit growth until the trend reverses itself.
When the price is observed to be generally higher than the moving average, it is thought to be an uptrend market. This is also known as a bullish trend.
When the price action is generally below the moving average points, the market is observed to be in a downtrend. This is also called a bearish trend.
Downtrends can be great for short-sellers as they can take advantage of quick changes in the economy; however, if the trader likes to be in trades for a long period of time. This is because the price of the stock will fall lower than the price it was bought at. This is sure to bear losses.
Now that we have understood the types of moving averages and market trends, it's time to look at various utilities of the former. The following sections will talk about all the utilities that can be taken out of moving averages and how they affect not just a single trader's trade but the entire market.
How to Use Moving Averages to Find A Trend
There are many ways to use moving averages to figure out market trends. Experienced traders know how to figure out trends through experience. However, new traders generally suffer to find the right trading trend. Given below are some methods through which you can figure out the market trend with the help of moving averages.
The very first thing that needs to be done to figure out market trends is plotting moving averages on a chart and using them for visual analysis. After plotting the moving average on the chart, plotting of price fluctuations enables us to see the trend style. It is now that various methods can be used to understand the basic market trends that are prevalent.
Moving Average Crossover - Conventional Method
The crossover method requires to see where the price line intersects with the average line.
When the price line cuts the average line from above, the market is said to be in a downtrend. Opposingly, when the price line cuts the moving average line from below, the market is said to be in an uptrend.
Even though this is an effective way of figuring out market trends through moving averages, it is too simple to be the primary method of analysis. This analytical method can lead to faulty analysis and hence, grave losses. This problem majorly exists in sideways markets.
Moving Average Slope
There is no simple method of determining market trends than this one. The only thing that needs to be focused on the slope of the moving average in this trend.
If the slope of the moving average line is upward, the market is in a bull trend. However, if the slope is moving downward, the market is in a bear trend.
The simplicity and responsiveness of this method are what make it very effective even though it only replies on the moving average. This allows us to forget about the main factor itself - the price action.
Swing Pivot Confirmation
Unlike the moving average slope method, this method is solely focused on the price action. This method saves the trader from falling into the pitfall of being reliant on the indicator instead of the real factor.
This method helps in determining a bullish trend when the price line reaches a new high without even coming down to the moving average point. Whereas a bearish trend is determined when the highest price high does not reach the moving average line.
Other ways to successfully analyze trades is by the help of moving averages are discussed in the later sections of this article. Some of these methods include using envelopes, ribbons, and resistance points to know when the market trend will take a sharp turn.
Getting In and Out of Trades on the Basis of Market Trends
The purpose of the previous sections was to accustom you to what moving averages are and how they can be used to analyze market trends. Now you know how to plot moving averages on a financial chart and how to determine financial trends. With that knowledge, you must also understand how to use trends to get into trades of buying and selling stocks.
The most important part of stock trading is to know when a trend is about to end. This is because with every end comes a reverse. Suppose you have stocks in an upward trade and can understand when the market is going to reverse. This is because a shift from upward to downward market is detrimental to revenue generation.
If the trend is upward, treaders generally want to ride the profitability for as long as possible to gain maximum profits. It is crucial for new traders to figure out when is the right time to get into a trade and when is the right time to get out of it.
Some trends are short-lived, while other trends might last for weeks or months. It is crucial for a trader to know the pivoting points of the market trend.
A technical tool for determining the different marketing trend shifts is the moving average crossover observation. Moving average crossovers help traders understand when to enter or exit trades.
How to Use Moving Average Crossovers to Enter Trades
A moving average crossover occurs when two moving average lines cross one another. This moving average crossover is the right way to understand the bulk of a trend. These, much like moving averages themselves, cannot identify the trends accurately. This is because these are lagging indicators.
Crossovers are the primary strategies that are applied to moving averages. The perfect way to know whether the market is on uptrend or downtrend is by looking at crossovers in a financial map. The way the trends can be recognized through crossovers is explained in the previous sections.
These three primary questions arise in the minds of new traders when thinking of entering or exiting a trade. All these questions are answered well through a moving average crossover system.
In which direction might the market price be trending?
When is it possible for a trend to reverse or end?
Where are the perfect entry and exit points in trade according to the market trends?
Once you successfully plot some moving average on a chart and analyze for crossovers, you will be able to find answers to each of these questions.
Question 1 - In Which Direction Might the Market Price be Trending?
The answer to this question has been given in a previous section. To recap, one must remember the following two things.
If the price line cuts the moving average line from above, the market is trending downward.
If the price line cuts the moving average line from below, the market is trending upward.
Question 2 - When is it Possible for a Trend to Reverse or End?
A crossover signifies a change in trend in the market. This is because when the price line crosses with the moving average line, it is obviously going in a direction other than it previously was.
Therefore, whenever the moving averages cross over each other, the market trend is going through a change. This change will mostly result in a reversal, but in some circumstances, it is possible for the market to go further in the same direction. Whatever the case is, the market will surely see a change in momentum.
Question 3 - Where Are the Perfect Entry and Exit Points in a Trade According to the Market Trends?
The right entry and exit points can be easily recognized through market trends. Entry and exit should be done at the time of crossovers. This means that entry and exit are only ideal when the market is witnessing some kind of trend shift.
In ideal situations, the right time to enter the market is when it is moving into an upward trend. This is because, at this time, the trader will be able to buy stocks at a lower cost than usual. This decreases the investment cost of the entire trade.
The right exit point is usually when the trend is towards the end of a downward trend. This is because the cost of stock is usually high at this time. This allows the trader to sell stocks at a much higher price than at which they bought them.
The overall benefit of each trade depends on the kind of stocks the trader is dealing with. But it is always ideal for marking entry and exit points towards the beginning or end of a market trend.
How to Use Moving Averages as Dynamic Support and Resistance Levels
A great utility of moving averages is their role played in dynamic support and resistance levels. The reason why the support is referred to as dynamic is that the market is constantly changing in accordance with the recent action of price. This is why many forex traders refer to moving averages for support or resistance.
One important thing to remember about price and moving averages is that the price will never bounce perfectly from the average. This is because the average assimilates all price actions and does not concentrate on any one action. Therefore, sometimes the price might go a little past the line before coming back to the trend’s direction.
It is also possible that at times the price will go completely off-track, but after a few price actions, it will come right back on track again. Therefore, some areas between moving averages are completely off the price line. Forex traders generally buy or sell lots only when the price is the middle of two moving averages. This allows for a more accurate pricing estimate.
These middle trading areas are called the zones. This is how moving averages act as support and resistance.
A great thing about moving averages is that they are dynamic in nature and are, therefore, ever-changing. This is why the trader can leave these averages plotted on a chart and without having to keep referring to the spot that might provide support or resistance since the support and resistance keep fluctuating too.
How to Use Moving Average Envelopes
It is no secret by now that moving averages are one of the easiest to use market technical tools available. You also know how simple moving averages are calculated and how they can be plotted onto a chart to analyze trends. These trends can then be used to make the right trading choices that finally affect the entire trading business.
With all that information, you should know something about buying and sell signals. Buy signals generally occurs when the closing of prices occurs well over the moving average. At this point, it is a great idea to buy stocks. A sell signal occurs when the prices do not come at par with the moving average at the time of closing.
In order to limit the number of trades, technicians came up with the idea of envelopes. These envelopes are small lines that are added below and above the moving average line. These lines limit the number of trades because trades are only accepted if the price line is encased in the envelope.
Envelops are usually placed at 5% above and below the moving average line. By drawing envelopes, technicians are able to hide unestablished buy and sell signals. This allows for fair and regulated trading.
The idea of envelopes, however, fails because whipsaw trades happen anyway. The only difference between trades with or without envelope is that with them, these trades occur at different price points.
Envelops help in identifying trend changes. However, a great another benefit of the envelope is something that only keen observers could figure. The fact is that when the price line touches either of the envelopes, the price tends to either reverse or go slightly in the other direction.
This is an interesting observance because this means that price is incapable of going over 5% in either direction of the moving average line.
Moving average envelopes make spotting trends even easier the before. They create a more precise tool for trend observation. This is why many traders rely on envelopes not only to create a healthy trading market but also to identify solid trend shifts.
How to Analyze Trends with Moving Average Ribbons
Moving average ribbons are interesting. They are a great way to analyze market trends. However, this method is a little complicated. It is still an interesting tool to have at hand, and many traders trust this method immensely.
Moving average ribbons are formed when a series of moving averages of varying lengths are put together on a chart. For a good trend analysis to occur, the minimum of moving averages to be plotted on a chart should be six, and the number can increase up to 16 or so.
With the help of moving average ribbons, traders can figure the strength of the trend. The smoothness of the ribbon allows for a decent determination of market trend strength. Key resistance and support points can be identified by means of putting the price line over the ribbon. By doing so, the relation indicated various relative points that can help in identifying support and resistance points.
Using Ribbons to Find Trend Ends
Ribbon expansion occurs when moving averages start to separate and widen from each other on different moving average lines. This expansion is a signal towards the extreme changes in price points. With such an expansion, traders can be assured that a trend is ending.
Moving average ribbons tend to be stuck close to each other. This is why when they are close to each other, a trend seems to be strong. However, as they start to get far away from each other, the strength of a trend begins to break. This is what causes a trend to break, end, and turn in a reverse direction.
Using Ribbons to Find Changes in Trends
Ribbon contraction occurs when all the moving average lines start to get extremely close to each other. When overlapping occurs, trades find a possible change in trend. While this trend change could be a thing of the future, but in most cases, contraction means that trend changes have already started to take place in the market.
When there is an extreme change in prices in a singular direction, the shorter-term moving average lines unite well before the longer-term moving average lines do.
Using Ribbons to Determine Trend Strength
A parallel distribution and correlation of all the varied time moving average lines is a positive signal for long-term traders. This is because parallel and evenly spaced ribbons signal that the trend is strong. An agreement in moving averages shows strength and long-term sustenance of the current market trend.
How to Trend Trade with Guppy Multiple Moving Average (GMMA)
Guppy Multiple Moving Average (GMMA) is another technical identifier that serves similar purposes as moving averages. GMMA, too helps technical traders in identifying changes in trends, trend breakouts, and trading opportunities.
GMMA identifies all the above-mentioned things by forming a combination of two moving average groups of varied time periods. These groups are made with the help of using different short-term and long--term trends in the market. A good combination of GMMA includes six short-term and six long-term moving averages. All of these are exponential moving averages.
These groups are essentially moving average ribbons, and the application of GMMA gives an exciting approach to the previously explained moving average utility through ribbons.
The point of using moving averages is not only to identify trends but to be able to catch them and take advantage of them. This helps in getting in and getting out of rends with ease.
The utility of moving averages to understand when to get in and get out of a trade is called trend trading. The use of the GMMA indicator allows traders to do just that.
Identifying Trends Through GMMA
The Guppy Multiple Moving Average helps in finding changes in trends and gauging the strength of the currently prevailing market trend. This is done in the opposite manner to moving average ribbons.
When there is a wide separation between the long-term and the short-term moving averages, the current trend is extremely strong. However, a narrow separation indicates a period of consolidation or a trend that is rapidly weakening.
The crossover technique is also identifying in the process. A reversal in trend can be expected when the long-term and the short-term moving average ribbons have a crossover.
When the short-term exponential moving average ribbons are higher than the long-term exponential moving average ribbons, the trend is going towards an upward turn. However, when the long-term exponential moving average ribbons are higher than the short-term exponential moving average ribbons, the trend is going to take a downward turn.
A lack of trend is identified when both the exponential moving average groups run parallelly together.
Trading With GMMA
As explained above, an upward trend is marked by the short-term group being higher than the long-term group. This strong uptrend is highlighted further when the two groups do not intersect with each other at all. This is a buy signal in the trade.
The sell signal in the trade is visible when the long-term group is higher than the short-term group.
Overall, trading with trends set up with the help of GMMA bears greater fruits than expected from any trading trend.
Moving Average is a powerful technical trading tool that is used by most traders to be cautious about prevailing and future market conditions. They help in identifying market momentum, which in turn increases the vigilance that traders exercise while entering and exiting trades.
An understanding of moving averages helps traders to identify market trends that greatly impact the way prices fluctuate in the market. They also help in analyzing various other technical identifiers.
In order to be a successful trader who makes maximum profits out of unexpected situations, using moving averages is a good idea. Trading with the trend is the best way to get the most out of a technical trader’s skills.