Introduction
Moving Averages is the oldest technical indicator used by the trader. It was drawn by hand before computers were used in technical analysis. It is beneficial for any trader and has a lot of trading applications.
What is a Moving Average?
It is a mathematical calculation used to decrease the short-term noise or short-term volatility in price movement. It is a lagging indicator that means it never anticipates price movement. It only tells us that prices have moved upward or downward.
What types of Moving averages?
Moving averages have many types. These types came from different ways of calculating the moving average to make the average more sensitive to price action.
Types of Moving Average:
1- Simple Moving Average (SMA)
SMA = (Sum (Price, n)) / n
Where: n = Time Period
2- Linear Weighted Moving Average (LWMA)
LWMA= (Pn∗W1) +(Pn−1∗W2) +(Pn−2∗W3) / ∑W
3- Exponential Moving Average (EMA)
EMA = Closing price x multiplier + EMA (previous day) x (1-multiplier)
4- Smoothed Moving Average (SMMA)
SMMAi = (Sum - SMMAi-1) / N
where:
SMMAi - is the value of the period being calculated.
Sum - is the sum of the source prices of all the periods over which the indicator is calculated.
Figure 1
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There are more types of Moving averages, but these are the most commonly used in trading applications. All these calculation types try to decrease moving average lagging time and increase its response to price movements. All moving average types are used the same way. figure (1) shows the different types of moving averages
How to use Moving averages in trading?
Moving averages have many trading applications. the most useful one is defining the price trend, generating trading signals, and using it as support or resistance
Using Moving averages to know what the price trend is?
1- Using One moving Average
A- Price Relative to Moving Average
When prices move above the moving average means that prices are better than their average, which indicates buyers are in control; when prices move below its moving average means sellers are in control of that period, as shown in figure (2)
B- The Slope of Moving Average
When the slope of the moving average is upward, it means the current trend for that period is up, and when the slope of the moving average is downward means the current trend for that period is down, as shown in figure (2).
Figure 2
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2- Using Two Moving Average
Using two moving averages is very useful for a trader to see different price cycles in the same chart. When the faster moving average is moving above, the longer moving average prices move in an uptrend. When the faster-moving average is moving below the slower one, the prices move in a downtrend, as shown in figure (3).
Figure 3
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Moving Average as Support and Resistance
When prices move above the moving average, it usually acts as dynamic support, and when prices move below the moving average, it usually acts as dynamic resistance, as shown in figure (4)
Figure 4
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Using Moving averages for trading signals
1- One Moving Average
A- The Cross over between the price and moving average
Buy Signal is triggered When prices cross above the moving average.
A sell signal is triggered when prices cross below the moving average, as shown in figure (5)
The cross over occurs when two candles close above or below the moving average for more confirmation and to decrease the false signals The disadvantage of this way of signals is that there will be many whipsaws or false signals
Figure 5
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Buy when the slope of the moving average turns upward
Sell when the slope of the moving average turns downward, as shown in Figure (6)
Signals trigger from the slope of the moving average is more stable and accurate than the crossover, but it slower than the crossover
Figure 6
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2- Two Moving averages
We use a slower moving average to determine the long-term market trend and the faster-moving average to time the entry signal
Buy signal is triggered when the faster average crossover above the slower average
Sell signal is triggered when the faster average crossover below the slower average
As shown in figure (7)
Figure 7
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Buy signal is triggered when the slope of the faster-moving average turns upward when the slope of the slower moving average is upward, as shown in figure (8)
Figure 8
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Sell signal is triggered when the slope of the faster-moving average turns downward when the slope of the slower moving average is downward, as shown in figure (9)
Figure 9
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3- Three Moving Averages
We use three moving averages to show three trend cycles, the long-term moving average for the long-term cycle, the medium-term average for the medium-term cycle, and the medium-term moving average for the short-term cycle. Buy signal is triggered when the short-term MA cross above the medium term, but the medium-term MA must be above the long-term MA, as shown in figure (10)
Figure 10
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Sell signal is triggered when the short-term MA cross below the medium term, but the medium-term MA must be below the long-term MA, as shown in figure (11).
Figure 11
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How to close a current position?
We mentioned how to use one, two, and three moving averages to enter a position, so how to close those positions? We can get out of a position when an opposite signal occurs or using any exit strategy such as using a fixed target or any trailing stop methods
When you should avoid using averages?
Moving average is a trending indicator that means it should use when prices move in a clear direction. You should avoid any trading signals in a sideways market and wait until that sideways end and a new trend begins, either upward or downward. as shown in figure (12), there are many false signals during a sideways market.
Figure 12
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What is the problem with Moving average trading systems?
Moving averages trading system is a profitable system, but it has a low winning probability ratio of less than 50%, but it has a high risk to reward ratio, which means one winning position can offset 3 losses.
Conclusion
Moving Averages are the oldest trading indicator used by traders because it calculated easily when there were no computers, and now they have many trading applications and they are very useful to every kind of trader.
The content published above has been prepared by CFI for informational purposes only and should not be considered investment advice. Any view expressed does not constitute a personal recommendation or solicitation to buy or sell. The information provided does not have regard to the specific investment objectives, financial situation, and needs of any specific person who may receive it, and is not held out as independent investment research and may have been acted upon by persons connected with CFI. Market data is derived from independent sources believed to be reliable, however, CFI makes no guarantee of its accuracy or completeness, and accepts no responsibility for any consequence of its use by recipients.