They can help you identify buy and sell signals, as well as trends in the market. In this post, we’ll cover how to use moving averages in your trading strategy. We’ll also look at some tips for using them effectively. Let’s get started!
We will start with an explanation of what moving averages are, the different types of moving averages and how they are calculated. We will look at how to use moving averages in trend analysis and for support and resistance. Finally, we will conclude with how you can use moving averages effectively in your trading.
- What Is a Moving Average?
- Different Types of Moving Average and How To Calculate Them
- How To Use Moving Averages in Your Trading?
- Moving Average Top Takeaways
What Is a Moving Average?
A moving average is a technical analysis tool that helps smooth out price action by filtering out the “noise” from random price fluctuations. It is calculated by taking the average of a market’s price over a set period of time. The moving average can be applied to any data series, including stocks, equity indices, commodities and Forex. Moving averages are often used to identify trends or support and resistance levels. They can also be used to generate buy and sell signals. There are many different types of moving averages, including simple moving averages, weighted moving averages and exponential moving averages. The choice of which moving average to use depends on the trader’s strategy, goals and trading style.
Different Types of Moving Average And How To Calculate Them
There are three main types of moving averages that are commonly used by traders:
- Simple Moving Average (SMA)
- Weighted Moving Average (WMA)
- Exponential Moving Average (EMA)
Simple Moving Average (SMA)
A simple moving average (SMA) is calculated by adding up the last n prices and then dividing by n. The SMA is one of the most popular technical indicators used by traders and investors.
A SMA for n periods is calculated as below:
SMA = (P1 + P2 + …… + An) / n
Where Pi is the data point in the ith period.
Weighted Moving Average (WMA)
Weighted moving averages (WMA) are a type of moving average that places more importance on recent data points. Whereas a SMA takes the average of a given set of data points, a WMA assigns different weights to each data point, with more recent data points receiving higher weights. This makes a WMA more responsive to changes in the more current, underlying data, which can be useful for trend-tracking purposes.
A WMA for n periods is calculated as below:
WMA = (P1*W1 + P2*W2 + …… + Pn*Wn)/ n
where Pi and Wi are the data point in the ith period and weighting, respectively.
Exponential Moving Average (EMA)
The exponential moving average (EMA) is a type of moving average that is similar to an SMA and even more akin to a WMA, except that more emphasis is given to the most recent data. This means that exponential moving averages can often react more rapidly to recent changes in price. EMAs are also sometimes referred to as exponentially weighted moving averages. The EMA calculation is slightly more complex than for the SMA or WMA.
An EMA for n periods is calculated as below:
EMA = (C – P) * (2 / (n + 1)) + P
where C and P are the current data points and an exponential moving average of the previous period, respectively (SMA used for the first period).
How To Use Moving Averages In Your Trading?
We will look at three main ways we will look at to use moving averages in your trading:
- Trend direction
- Support and resistance
- Moving average crossovers
Quite simply, the direction that the moving average is pointing, up, down or sideways, tells us the underlying trend of the market. The longer the moving average, that is, the bigger the number of data points, the more it will tell us about a longer-term trend. So, on a daily chart, a 10-day moving average will tell us about the short-term trend, but a 200-day moving average will tell us more about the much longer-term trend. In addition, if we look at a short-term time period, so a 30 or 5-minute chart, this is going to tell us more about intraday trend direction.
Support And Resistance
A moving average can be used as a simple form of support and resistance. When the price is above the moving average, it can be seen as support. Similarly, when the price is below the moving average, it can be seen as resistance. So, you may design a trading strategy that includes a signal for when the price breaks above or below a certain moving average on a defined time period of the chart. The length of the moving average and the time frame of the chart will depend on your strategy. And you may use the moving average as support and resistance as a primary factor in your strategy, or it could be used as an additional qualifying factor for a bigger strategy using other indicators.
Moving Average Crossovers
A moving average crossover occurs when one moving average crosses above or below another moving average of a differing length and can be used as a signal of a trend reversal. When a shorter (lower number of calculated period n) moving average crosses above a longer moving average (higher number of calculated period n), this can be used as a buy signal. And when a shorter moving average moves down below a longer moving average, this can be seen as a sell signal. Again, the lengths of two moving averages and the time frame of the chart will depend on your own personal trading strategy and should be back-tested to optimise which moving average lengths to use.
Moving Average Top Takeaways
Moving averages are one of the most commonly used technical indicators in trading. In this blog post, we’ve explained what a moving average looked at three different types of moving averages, plus how to calculate them. We have also discussed how to use them in your trading. If you want to learn more about technical analysis, go to our Learning Hub and for other helpful trading hints, be sure to check out our other blog posts.