Moving averages can help you determine the direction of a current trend while minimising the impact of price volatility. But how much data do you need to build a reliable picture of the trend? Let’s look here.
What is Moving Averages?
A moving average is the average price of a security over a set period of time. By plotting the average price, sharp fluctuations are removed, and it is easier to identify the true trend.
In simple terms, moving averages help technical traders smooth out some of the noise in the market. You can use them to identify current trends, trend reversals, and to set up support and resistance levels.
There are several different ways of looking at moving averages with a variety of calculations. However, the interpretation of each moving average remains the same. The calculations only differ in regards to the weighting that they place on the price data.
In moving averages, you shift from weighting each price point equally, to placing more weight on recent data. The most common types of moving averages are simple, exponential and weighted. Having a thorough understanding of the exact calculation isn’t generally required as most charting software will do the calculation for you.
Simple Moving Average (SMA)
SMA is the most common method used to calculate the moving average of prices. Each point is calculated as the sum of all previous closing prices over the time period, divided by the number of prices used in the calculation.
For example, a 21 day SMA, uses the last 21 closing prices added together and divides it by 21.
Weighted Moving Average (WMA)
The Weighted Moving Average is used to address the problem of equal weighting. It’s calculated by taking the sum of all the closing prices over a specific time period, multiplying them by the position of the data point, and then dividing by the sum of the number of periods. This is also referred to as “linear weighted,” as the decline in weighting is done on a linear basis.
Exponential Moving Average (EMA)
The Exponential Moving Average calculation uses a smoothing factor to give a higher weighting to recent data points. The difference with the weighted moving average is that the weighting decreases on an exponential basis (as opposed to a linear basis with the WMA).
The most important factor to remember here is that the EMA is more responsive to new information relative to the SMA. This responsiveness is one of the key reasons why it is the moving average of choice for many technical traders. It is generally considered much more efficient than the WMA.
Figure 1: Simple, Weighted and Exponential Moving Averages on GBP/USD
Which Moving Averages Should I Use?
Moving averages are effectively an indicator of trend. Therefore, in the same way, as you can look at trends of different time horizons, you can look at a different number of periods for moving averages.
There is no hard-and-fast rule for which moving averages you should use. On daily charts, some traders like to use round numbers, such as 20, 50, 90 and 200-day moving averages, while others may use Fibonacci numbers, such as 21, 55, 89 and 144-day moving averages.
As a general rule, a 200-day moving average is thought to be a good measure of a long term trend, a 90-day moving average of a medium- to long-term trend, a 50-day moving average the medium-term trend, and a 20-day moving average of a short term trend.
You should also understand that moving averages work differently at different times and in different markets. Some moving averages may work very well for one instrument but not so well for another. So it is crucial to have a range of moving averages on charts.
It is a case of horses for courses as there is rarely a one-size-fits-all option. And a moving average that worked well six months ago may not be such a good indicator now.
Trading with Moving Averages
Having decided whether to use simple, weighted, or exponential moving averages, as well as the different moving average periods, you can now start looking for trading signals.
It is important to note that trading using moving averages works best in a trending market. Sideways or ranging markets will result in moving averages posting frequent false signals, which can lead to losses.
You can use the direction of the moving average to identify whether the price is moving in an uptrend (bullish) or a downtrend (bearish).
- When a moving average is advancing, and the current price is rising above it, this is considered to be bullish, where traders would be looking for buying
- Conversely, a downward sloping moving average with the price falling below it signals a bearish market where traders should be looking for selling
Another signal of a trend reversal is when one moving average crosses through another. When a shorter moving average crosses above a longer moving average, this can be used as a buy signal. Alternatively, a shorter moving average falling below a longer moving average can be seen as a sell signal.
There can be an extra conviction in moving average crosses if both are moving in the same direction at the time of the cross.
- A “Golden Cross” is where a rising shorter moving average rises above a rising longer-term moving average.
- A “Death Cross” or “Dead Cross” is where a falling short term moving average falls below a falling longer-term moving average.
As seen on Dollar/Yen chart below, the crossovers of the 21-day SMA and the 55-day SMA proved to be excellent signals for trend changes and generated a series of buy and sell signals during 2018 and 2019.
Figure 2: Crossovers of the 21-day SMA and 55-day SMA on USD/JPY