Moving Averages
A moving average is simply a way to smooth out price action over time.By “moving average”, we mean that you are taking the average closing price of asecurity for the last ‘X’ number of periods.
On a chart, it would look like this:
Like every indicator, a moving average indicator is used to help us forecast future prices. By looking at the slope of the moving average, you can better determine the potential direction of market prices.
As we said, moving averages smooth out price action.
There are different types of moving averages and each of them has their own level of “smoothness”.
Generally, the smoother the moving average, the slower it is to react to the price movement.
The choppier the moving average, the quicker it is to react to the price movement.
To make a moving average smoother, you should get the average closing prices over a longer time period.
Now, you’re probably thinking, “C’mon, let’s get to the good stuff. How can I use this to trade?”
In this section, we first need to explain to you the two major types of moving averages:
- Simple
- Exponential
We’ll also teach you how to calculate them and give the pros and cons
of each. Just like in every other lesson in the BabyPips.com School of
Pipsology, you need to know the basics first!
After you’ve got that on lockdown like Argentinian soccer player Lionel Messi’s ball-handling
skills, we’ll teach you the different ways to use moving averages and
how to incorporate them into your trading strategy.
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 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:
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.
- 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.
- The second crossover of the quickest SMA (10-day) and the slowest SMA (50-day) finally triggers the buy or sell signal.
- 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.
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 chart below of stock illustrates the visual difference between a 10-day Weighted Moving Average and a 10-day 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 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).
