Moving Averages

 Moving Average Indicator

Moving averages provide an objective measure of trend direction by smoothing price data. Normally calculated using closing prices, the moving average can also be used with median, typical , weighted closing, and high, low or open prices as well as other indicators.

Moving Average Types

There are several different types of moving averages, each with their own peculiarities.

    Simple moving averages are the easiest to construct, but also the most prone to distortion.
    Weighted moving averages are difficult to construct, but reliable.
    Exponential moving averages achieve the benefits of weighting combined with ease of construction.
    Wilder moving averages are used mainly in indicators developed by J. Welles Wilder. Essentially the same formula as exponential moving averages, they use different weightings — for which users need to make allowance.

 Moving Average Time Frames

Shorter length moving averages are more sensitive and identify new trends earlier, but also give more false alarms. Longer moving averages are more reliable but less responsive, only picking up the big trends.

Use a moving average that is half the length of the cycle that you are tracking. If the peak-to-peak cycle length is roughly 30 days, then a 15 day moving average is appropriate. If 20 days, then a 10 day moving average is appropriate. Some traders, however, will use 14 and 9 day moving averages for the above cycles in the hope of generating signals slightly ahead of the market. Others favor the Fibonacci numbers of 5, 8, 13 and 21.

    100 to 200 Day (20 to 40 Week) moving averages are popular for longer cycles;
    20 to 65 Day ( 4 to 13 Week) moving averages are useful for intermediate cycles; and
    5 to 20 Days for short cycles.


 Trading Signals

The simplest moving average system generates signals when price crosses the moving average:

    Go long when price crosses to above the moving average from below.
    Go short when price crosses to below the moving average from above.

The system is prone to whipsaws in ranging markets, with price crossing back and forth across the moving average, generating a large number of false signals. For that reason, moving average systems normally employ filters to reduce whipsaws.

More sophisticated systems use more than one moving average.

    Two Moving Averages uses a faster moving average as a substitute for closing price.
    Three Moving Averages employs a the third moving average to identify when price is ranging.
    Multiple Moving Averages use a series of six fast moving averages and six slow moving averages to confirm each other.
    Keltner Channels use bands plotted at a multiple of average true range to filter moving average crossovers.
    The popular MACD ("Moving Average Convergence Divergence") indicator is a variation of the two moving average system, plotted as an oscillator which subtracts the slow moving average from the fast moving average.

1. Simple Moving Average

The Simple Moving Average is arguably the most popular technical analysis tool used by traders. The Simple Moving Average (SMA) is used mainly to identify trend direction, but is commonly used to generate buy and sell signals. The SMA is an average, or in statistical speak - the mean. An example of a Simple Moving Average is presented below:

• The prices for the last 5 days were 25, 28, 26, 24, 25. The average would be (25+28+26+26+27)/5 = 26.4. Therefore, the SMA line below the last days price of 27 would be 26.4. In this case, since prices are generally moving higher, the SMA line of 26.4 would be acting as support (see: Support & Resistance).

The chart below shows a 20-day Simple Moving Average acting as support for prices.

Moving Average Acting as Support - Buy Signal

When price is in an uptrend and subsequently, the moving average is in an uptrend, and the moving average has been tested by price and price has bounced off the moving average a few times (i.e. the moving average is serving as a support line), then buy on the next pullbacks back to the Simple Moving Average.

A Simple Moving Average can serve as a line of resistance as the chart shows:

Moving Average Acting as Resistance Sell Signal

At times when price is in a downtrend and the moving average is in a downtrend as well, and price tests the SMA above and is rejected a few consecutive times (i.e. the moving average is serving as a resistance line), then buy on the next rally up to the Simple Moving Average.

The examples above have been only using one Simple Moving Average; however, traders often use two or even three Simple Moving Averages. The advantages to using more than one Simple Moving Average is discussed on the next page.

2. Moving Average Crossovers

Moving average crossovers are a common way traders use Moving Averages. A crossover occurs when a faster Moving Average (i.e. a shorter period Moving Average) crosses either above a slower Moving Average (i.e. a longer period Moving Average) which is considered a bullish crossover or below which is considered a bearish crossover.

The chart below shows the 50-day Simple Moving Average and the 200-day Simple Moving Average; this Moving Average pair is often looked at by big financial institutions as a long range indicator of market direction:

Note how the long-term 200-day Simple Moving Average is in an uptrend; this is a signal that the market is quite strong. Generally, a buy signal is established when the shorter-term 50-day SMA crosses above the 200-day SMA and contrastly, a sell signal is indicated when the 50-day SMA crosses below the 200-day SMA.

In the chart above of the S&P 500, both buy signals would have been extremely profitable, but the one sell signal would have caused a small loss. Keep in mind, that the 50-day, 200-day Simple Moving Average crossover is a very long-term strategy.

For those traders that want more confirmation when they use Moving Average crossovers, the 3 Simple Moving Average crossover technique could be used. An example of this is shown in the chart below.

 The 3 Simple Moving Average method is usually interpreted as follows:

1. The first crossover of the quickest SMA (in the example above, the 10-day SMA) across the next quickest SMA (20-day SMA) acts as a warning that prices are reversing trend; however, usually a buy or sell order is not placed yet.
2. The second crossover of the quickest SMA (10-day) and the slowest SMA (50-day) finally triggers the buy or sell signal.

There are numerous variants and methodologies for using the 3 Simple Moving Average crossover method, some are provided below:

• A more conservative approach is to wait until the middle SMA (20-day) crosses over the slower SMA (50-day); but this is basically a two SMA crossover technique, not a three SMA technique.
• A money management technique of buying a half size when the quick SMA crosses over the next quickest SMA and then the other half when the quick SMA crosses over the slower SMA.
• Instead of halves, buy or sell one-third of a position when the quick SMA crosses over the next quickest SMA, another third when the quick SMA crosses over the slow SMA, and the last third when the second quickest SMA crosses over the slow SMA.

Moving Average crossovers are important tools in a traders toolbox. In fact crossovers are included in the most popular technical indicators including the Moving Average Convergence Divergence (MACD) indicator (see: MACD). Other moving averages deserve careful consideration in a trading plan.

3. Exponential Moving Average (EMA)

The Exponential Moving Average (EMA) weighs current prices more heavily than past prices. This gives the Exponential Moving Average the advantage of being quicker to respond to price fluctuations than a Simple Moving Average; however, that can also be viewed as a disadvantage because the EMA is more prone to whipsaws (i.e. false signals).
The chart below of eBay (EBAY) stock shows the difference between a 10-day Exponential Moving Average (EMA) and the 10-day regular Simple Moving Average (SMA):

The main thing to notice is how much quicker the EMA responds to price reversals; whereas the SMA lags during periods of reversal.
The chart below shows the difference between moving average crossovers (see: Moving Average Crossovers) buy and sell signals with a EMA and a SMA.

As the chart above illustrates, even though EMA's are quicker to respond to price movement, EMA's are not necessarily faster to give buy and sell signals when using moving average crossovers.
Also note that the concept illustrated in the chart above with Exponential Moving Average crossovers is the concept behind the wildly popular Moving Average Convergence Divergence (MACD) indicator; (see: MACD).
Since Exponential Moving Averages weigh current prices more heavily than past prices, the EMA is viewed by many traders as quite superior to the Simple Moving Average; however, every trader should weigh the pros and the cons of the EMA and decide in which manner they will be using moving averages.
Nevertheless, Moving Averages remain the most popular and arguably the most effective technical analysis indicator out on the market today.

4. Weighted Moving Average

The Weighted Moving Average places more importance on recent price moves; therefore, the Weighted Moving Average reacts more quickly to price changes than the regular Simple Moving Average (see: Simple Moving Average). A basic example (3-period) of how the Weighted Moving Average is calculated is presented below:

• Prices for the past 3 days have been $5, $4, and $8.
• Since there are 3 periods, the most recent day ($8) gets a weight of 3, the second recent day ($4) receives a weight of 2, and the last day of the 3-periods ($5) receives a weight of just one.
• The calculation is as follows: [(3 x $8) + (2 x $4) + (1 x $5)] / 6 = $6.17

The Weighted Moving Average value of 6.17 compares to the Simple Moving Average calculation of 5.67. Note how the large price increase of 8 that occured on the most recent day was better reflected in the Weighted Moving Average calculation.
The chart below of  stock illustrates the visual difference between a 10-day Weighted Moving Average and a 10-day Simple Moving Average:

Buy and sell signals for the Weighted Moving Average indicator are discussed in depth with the Simple Moving Average indicator (see: Simple Moving Average).

5. Adaptive Moving Average

Adaptive Moving Averages changes its sensitivity to price fluctuations. The Adaptive Moving Average becomes more sensitive during periods when price is moving in a certain direction and becomes less sensitive to price movement when price is volatile.
The chart below contract shows the difference between an Exponential Moving Average (see: Exponential Moving Average) which weights current prices more heavily than past prices and the Adaptive Moving Average which changes sensitivity based on price volatility:

The advantage of the Adaptive Moving Average is show above in the e-mini chart in the center where price became directionless and choppy. During that period the Adaptive Moving Average maintained a straight line appearance; whereas, the Exponential Moving Average moved with the choppiness of prices. However, when price trended, like on the far right of the e-mini chart above, the Adaptive Moving Average kept up with the Exponential Moving Average.
The Adaptive Moving Average is definitely an unique technical indicator that is worth further investigation.

6. Typical Price Moving Average

The Typical Price Moving Average combines the Pivot Point concept and the Simple Moving Average. The Pivot Point (see: Pivot Points) calculation is shown below:

• Pivot Point = (High + Low + Close) / 3

The calculated Pivot Point number is then inputted into the regular Simple Moving Average (see: Simple Moving Average) equation; rather than the input of the closing price, the Pivot Point calculation is used.
The chart below shows the slight difference between a 10-day Simple Moving Average and a 10-day Typical Price Moving Average:

The Typical Price attempts to give a more real representation of where price has been by incorporating the high and low price into the most often used closing price. The Typical Price is consequently seen as a more pure Simple Moving Average; nevertheless, as can be referenced by the chart above, there is not much difference between either Moving Average. Buy and sell signals for the Typical Price Moving Average indicator are discussed in depth on the Simple Moving Average indicator pages (see: Simple Moving Average).

7. Triangular Moving Average

The Triangular Moving Average is a Simple Moving Average that has been averaged again (i.e. averaging the average); this creates an extra smooth Moving Average line.
The chart below contract shows the relation between a 10-day Simple Moving Average and a 10-day Triangular Moving Average:

Generally, simple moving averages are smooth, but the re-averaging makes the Triangular Moving Average even smoother and more wavelike.
Buy and sell signals for the Triangular Moving Average indicator are discussed in depth on the Simple Moving Average indicator pages (see: Simple Moving Average).

Summary: Moving Averages

• There are many types of moving averages. The two most common types are a simple moving average and an exponential moving average.
• Simple moving averages are the simplest form of moving averages, but they are susceptible to spikes.
• Exponential moving averages put more weight to recent price, which means they place more emphasis on what traders are doing now.
• It is much more important to know what traders are doing now than to see what they did last week or last month.
• Simple moving averages are smoother than exponential moving averages.
• Longer period moving averages are smoother than shorter period moving averages.
• Using the exponential moving average can help you spot a trend faster, but is prone to many fake outs.
• Smooth moving averages are slower to respond to price action but will save you from spikes and fake outs. However, because of their slow reaction, they can delay you from taking a trade and may cause you to miss some good opportunities.
• You can use moving averages to help you define the trend, when to enter, and when the trend is coming to an end.
• Moving averages can be used as dynamic support and resistance levels.
• One of the best ways to use moving averages is to plot different types so that you can see both long term movement and short term movement.

You got all of that? Why don't you open up your charting software and try popping up some moving averages. Remember, using moving averages is easy. The hard part is determining which one to use! That's why you should try them out and figure out which best fits your style of trading. Maybe you prefer a trend-following system. Or maybe you want use them as dynamic support and resistance. Whatever you choose to do, make sure you read up and do some testing to see how it fits into your overall trading plan.