The moving average is one of the most popular and widely used trading indicators used by traders and technical analysts to identify the direction of the trend. Moving average generally sums up many data points of a financial asset over a time period and divides the total value by the number of data points. As the name implies, moving average usually recalculate the data after each candle is formed. Moving average is a great trading tool if know its uses. Most of the traders make some crucial mistakes while dealing with moving averages in their trading. If you start to use moving average just after seeing some moving average strategy on youtube it will cost you money. As a trader, you need to understand the core concepts of the indicators and how they work, and what are the best practices of using moving averages in trading. In this moving average guide, we will discuss various types of moving averages, which types of moving average will be best for your trading, and how can you use moving average while making trading decisions.
Moving average indicates the previous movements of price in a financial instrument. Traders and technical analysts use moving average not only to understand previous price movements but also for future trend direction. The concept of support and resistance is very popular in trading. Traders use the moving average as dynamic support and resistance. Many times you will find the price is bouncing off a moving average means that moving average is working as dynamic support in that particular asset. It’s called dynamic support because the moving average line is not fixed but it’s changing with the price. Many advance traders now give priority to dynamic moving average rather than static moving average as support or resistance.
Types of Moving averages:
There are two main types of moving averages.
Simple Moving Average:
Simple moving average (SMA) works by summing specific amounts of previous data points and diving by that specific number. For example, if you use a simple moving average (10), it will sum up the data points of the previous 10 candles and divide it by 10. A moving average can be calculated with various data sets like the high, low, open, close of the candles. Traders use a simple moving average to enter the market and also exit from the market based on their trading strategy. A simple moving average also helps traders to identify strong support and resistance in financial securities.
Exponential Moving Average:
It is another type of moving average which is also commonly known as EMA (exponential moving average). This type of moving average works by giving more weight to the recent price data. For this reason, the exponential moving average is more responsive to recent price data points. When price changes its direction, exponential moving average shows the more quick response of the price change compared to the simple moving average. Thus, the exponential moving average provides a buy and sell signal earlier than the simple moving average.
Which moving average is best? Simple Moving Average or Exponential Moving Average?
Most of the traders ask this question at the beginning of their trading journey, whether they should use EMA or SMA. The right choice of moving average can play a vital role in your trading system. In this section, we will discuss the main difference between EMA & SMA and the pros & cons of them.
Difference between EMA & SMA:
The only major difference between them is speed. EMA moves faster than SMA and also changes its direction earlier than SMA. The reason behind the fast movement of EMA is it gives more weight to the recent prices where SMA is calculated by giving significance to all price values. As EMA gives more significance to recent prices when the price of a stock changes its direction exponential moving average can recognize this earlier than a simple moving average.
Many traders use SMA for its simplicity while others think EMA is more reliable because it gives more priority to recent data. Many traders prefer EMA because of its faster response to price changes.
Pros and Cons: EMA vs. SMA
EMA moves faster than SMA and when price changes its direction EMA can recognize it faster which also means EMA is more vulnerable than SMA and it can provide wrong signals to traders so early. When price makes a small retracement in a trend, sometimes EMA shows price changed its direction while SMA moves much slower and signals are comparatively less wrong. Another key thing to note, SMA provides signals much slower than EMA so many times you will miss significant movement if you follow SMA.
How to use moving averages in your trading:
Moving average is generally used to identify trends. Traders also use them as a dynamic support. In this section, we will discuss both of them.
Moving Average to identify trend:
When multiple moving averages are going in the same direction, it indicates the price is also moving in the same direction. For example, when the price is in an uptrend, if you add multiple moving averages like EMA (20), EMA (30), EMA (50), and EMA (200), you will see all of the moving averages is heading to the upside in the same direction of the trend. So, traders use them for simplicity. When they add a few moving averages in the price chart of any stock, they can clearly see whether the price is moving in an uptrend or downtrend or in a range. Without giving much attention to the candlesticks, they can understand the direction of the price. Even if you remove the candlestick from the chart and just use moving averages still you can understand the overall direction of the trend in that stock.
In the picture, 1H chart of Robi Axiata Ltd. with two exponential moving averages (13, 50) is shown. Here we can see price is running in a downtrend because it’s making a series of lower highs and lower lows. Here the blue line is the exponential moving average (13) and the yellow line is the exponential moving average (50). Both of the moving average heading towards the downside clearly indicate the overall price direction is in the downside. Traders who want to keep it simple and don’t want to analyze highs and lows to determine the trend, just plot a few moving averages which clearly indicates whether the price is in a downtrend or uptrend.
Moving Average Crossover:
Moving average crossover is also one of the most used moving average strategies for trading entry and exits. When a short-term moving average crosses through a long-term moving average, it’s known as moving average crossover. For example, if we add EMA (20) and EMA (50) in a chart, here EMA (20) is the short-term moving average because it counts the previous 20 candles and EMA (50) is the long-term moving average because its counts previous 50 candles.
When a short-term MA (moving average) crosses a long-term MA (moving average) to upside, it represents a buy signal. On the other hand, when a short-term moving average crosses a long-term moving average through the downside, it represents a sell signal.
When Simple Moving Average (50) crosses the Simple Moving Average (200) to the upside, it’s called a golden cross. The golden cross indicates the possibility of bullish momentum.
When simple Moving Average (50) crosses the Simple Moving Average (200) towards the downside, known as death cross indicating future bearish momentum.
Let’s look at a few moving average crossovers in a real chart.
In this picture, the blue line is SMA (50) and the yellow line is SMA (200). Here, SMA (50) crossed the SMA (200) line towards the upside indicating the possibility of an uptrend. After the crossover, there are series of higher highs and higher lows formed confirming the uptrend formation. Any trader who used this moving average crossover technique according to his strategy can generate huge profit from this strong bullish momentum.
In this picture, SMA (50) crosses SMA (200) towards the downside indicating future bearish momentum or downtrend. After the crossover, you can see there are a series of lower highs and lower lows confirming the downtrend. This type of crossover is often used by traders as an exit strategy. When they buy shares of a company and after a few days if they find a short term moving average is crossing a long term moving average towards the downside, they exit their position.
There is another type of moving average crossover technique used by traders in which they use just one moving average. In this strategy, they use a moving average in the chart, and when candles of a stock cross that moving average towards the upside, it indicates a buy signal or bullish momentum. On the other hand, when the candles cross that moving average towards the downside, it indicates a sell signal or bearish momentum. Let’s look at an example below.
Here price crossed the 200-period Moving average line towards upside which indicates strong bullish momentum. After the crossover, a series of higher highs and higher lows is formed confirming the uptrend.
Moving Average as a Dynamic Support and Resistance:
When price moves in a major trend, it makes many retracements against the major trend because that’s how the stock price moves in a trend like a wave. It never moves straight up or down. For example, in an uptrend generally, prices make retracement to the downside and then again make strong bullish momentum to upside breaking the previous high. When the price makes a retracement, the price of that stock is lower comparatively. So retracement zone is the best place where you can take a trade-in trend. To identify these retracement zones, many traders use the moving average as dynamic support or resistance. When price moves in an uptrend, many times you will see it makes a retracement to a major moving average and then again goes upside in its original direction. In a downtrend, the moving average works as a dynamic resistance.
In the picture above, the price was in an uptrend making higher highs and higher lows. In the arrow marked area, the price makes a retracement to the moving average and then goes back to its original direction towards the upside. This is how moving average is working as dynamic support here.
How to use moving average with chart pattern:
Many traders use moving averages with various chart patterns. After the formation of the chart pattern, they use moving average to take entries and exits. For example, if you want to take trades based on chart pattern and moving average, you can wait for a double bottom pattern form at the end of the downtrend and then use a moving average crossover to take long entries. On the other hand, if you bought some shares of a stock and want to use chart pattern and moving average as your exit strategy from that trade, you can wait for a double top pattern and a moving average crossover to the downside to exit from your trade.
In this chart picture above, a double bottom pattern is formed at the end of the downtrend which indicates there is a possibility of an uptrend to form. Two indicators used here are Simple Moving Average (13) and Simple Moving Average (20). After double bottom formed, traders should only look for moving average crossover to the upside as they want to buy this share. After forming the double bottom pattern, short term moving average (13) crossed the long-term moving average (20) towards the upside which is marked by the blue arrow. After this moving average crossover, a series of higher highs and higher lows formed. Any trader who took this trade can generate a good amount of profit from here. So, this is how you can combine moving average with chart patterns.
Moving average simplifies multiple price data and makes it easier for a trader to understand overall market condition within a very short time. It helps to understand the trend more easily. It’s not recommended to use any moving average trading strategy like moving average crossover as a standalone formula for trading entries. If you combine moving average with chart patterns, candlestick patterns then it will produce much better results.