What is a moving average (MA)?
A moving average is a technical indicator used to show the average value of an asset over a given period. It is designed to smooth out the ‘noise’ created by random price fluctuations. It is a lagging indicator based on past values such as high, low, open or close prices, or even volume.
There are different types of moving average indicators. The key difference between them is the weight that is assigned to different historic data points. For instance, the exponential moving average (EMA) places more weight on recent data, whereas the simple moving average (SMA) assigns equal weight across all prices.
The time frame for a moving average indicator can be as long or as short as desired. It can be calculated from minute-long, hour-long, daily, weekly, monthly or even yearly data. A trader can also use as many or as few time periods as they want to comprise the average.
A trader chooses their time frame based on the particular trend they are trying to trade. It is important to note that the greater the number of time periods, the smoother the average will be.
Simple moving average (SMA)
A simple moving average (SMA) is an arithmetic moving average. It is calculated by first adding the closing prices for a given number of time periods and then dividing that sum by the same number of time periods.
It generates a simple positive or negative trend to give traders a loose overall picture of the market. The larger the time period, the less volatile the simple moving average line.
Some traders are sceptical of simple moving averages because they believe that the most recent data carries the most weight and importance, as the simple moving average considers all closing prices equally.
Exponential moving average (EMA)
An exponential moving average (EMA) is a type of weighted moving average that places greater significance on the most recent data points. As such, it is more reactive to recent price changes than a simple moving average. This has the potential to help traders avoid missing the optimal point to open or close a position.
EMAs are useful to help spot sudden shifts in price movements. However, they are less accurate than SMAs when charting long-term trends. EMAs are also less useful at identifying levels of support or resistance than SMAs. For instance, an EMA could tip a trader out of a trade prematurely if a stock has a short dip.
Who invented the moving average?
Moving average indicators are one of the oldest tools in the field of technical analysis, originally published in the work of mathematician R. H. Hooker in 1901 who referred to them as ‘instantaneous averages’. The phrase was first coined in 1909 by Yule when describing Hooker’s process.
Why is the moving average useful for traders?
As far as technical analysis is concerned, moving averages are both simple and effective. Beginners can come up with a trading plan based on a moving average strategy with ease. Moving averages are effective because they have a wide applicability when trading markets.
Moving averages can be used to spot changes in price and detect trends, as well as generate trading signals. They can also be used to form dynamic support and resistance levels. These differ from traditional support and resistance levels because they are constantly moving.
Technical analysis: how to trade with a moving average indicator
There are a few things to consider when thinking about how to use a moving average in trading. Moving averages portray three different types of information to traders. This forms the basis of an individual’s moving average trading strategy.
- Trading signals
A trader can interpret MAs to generate buy and sell signals for any asset. This can be simply done by comparing the relationship between a moving average and the current market. If the current market price exceeds a rising moving average, this suggests a buy signal, whereas if the price falls below a falling moving average, it suggests a sell signal.
- Trend detection
Moving averages can be used to detect trends and changes in price. In other words, they can be used to help a trader determine the trend. A simple way to illustrate this is to plot an SMA and look for divergence within the price.
If price action were to stay above the SMA, this signals that the price is in a general uptrend. Conversely, if price action were to stay below the average, this signals a general downtrend.
More sophisticated traders combine different moving averages to produce more accurate buy and sell signals. This technique is known as spotting crossovers.
Combining the moving averages will generate clearer signals for traders. A price fall is indicated by a crossover of short-term moving average and the downward price movement. Similarly, a price rise is indicated by the intersection of the short-term moving average with an upward price movement.
- Support and resistance
Moving averages can also be used to form dynamic support and resistance levels for a market. Dynamic support and resistance levels differ from the traditional horizontal support and resistance lines. Dynamic levels are constantly changing because asset prices are constantly fluctuating, forming a series of differing peaks and troughs.
Using moving averages to identify resistance levels can be useful for a trader. It can signal when an asset is at its peak, suggesting that it is time to sell. Similarly, a trader can use MA to identify support levels and buy when price falls, testing the level. In some instances, historic resistance levels can then become current support levels.
Using moving averages to identify the four stages of the market cycle
A trader can use MAs to define the four stages of the typical market cycle that a security experiences. This, in turn, informs our trading strategy. Basing (stage 1) is where a market makes a transition from a major bear market to a major bull market. It is a period of base building as the market prepares to rally.
The market trades sideways as the asset moves; late-sellers close their positions and early-speculators enter. Shorter-term MAs start to illustrate more favourable patterns. Simultaneously, longer-term MAs continue to decline but at a lower rate of change. The price of the security will then stop trailing below key MAs and indeed break through them.
A rising market (stage 2) is where price increases are confirmed by the surpassing of initial resistance zones, forming a new price trend. Traders are aware that a substantial in market tone is occurring and start to buy aggressively.
Price dips are brief and tend not to touch the MAs. This is marked by intermediate- and then longer-term MAs joining short-term MAs in accelerating upwards.
A topping market (stage 3) is the situation where the market advance slows up. With units of the asset passing from earlier buyers to the hands of individuals who are late to purchase. This stage is characterised by the distribution of holdings from savy traders to latecomers.
The shorter-term, later followed by the intermediate- and longer-term, MAs lose momentum and begin to flatten. The price begins to trade sidewideways momentarily, as the peak is reached, then begins to decline leading into a bear market.
A declining market (stage 4) is when the bear market is in full effect. The asset price declines at an increasing pace. Short-term and then longer-term MAs start to fall at a lagged rate of acceleration. Price rallies are brief and tend not to touch the MA lines.