Most traders learn about moving averages when they first study technical analysis, but quickly abandon them as they learn about other more complex technical indicators. There’s a perception among some traders that successful trading systems need to be complex in order to be successful.
These perceptions aren’t exactly true. While a moving average crossover strategy won’t work for every security, simple strategies can be effective specific securities with the right settings. Moving averages can also be incorporated into more complex trading systems using other technical indicators.
Let’s take a closer look at moving averages and how traders at any skill level can use them to improve their performance.
What Are Moving Averages?
Moving averages represent the average price over a certain period of time. For example, a 50-day moving average takes the average closing price over the past 50 trading days and applies that value to the current day. The goal is to create a line that shows a trend in the price over time that’s easier to read than choppy day-to-day price movements.
Example of two moving averages.
Types of Moving Averages
There are many different ways to calculate moving averages. For example, displaced moving averages or moving average filters remove outliers to smooth the line without increasing lag time. Others apply more complex formulas to accomplish the same goals of smoothing the line and reducing lag time.
The two most common types of moving averages include:
- Simple Moving Averages: Simple moving averages, or SMAs, simply average prices over a specified period of time.
- Exponential Moving Averages: Exponential moving averages, or EMAs, assign a greater weight to more recent price action, which reduces the lag in reaction.
A 50-day EMA and a 50-day SMA plotted on the same chart showing the difference in lag time. Blue Line is the EMA and Red Line is the SMA.
The decision to use a SMA versus an EMA depends on the situation. EMAs quickly react to any market hiccups, which could stop out a trade too early. On the other hand, an SMA may be too slow to adapt to a changing trend and lead you to miss out on a move. Short-term traders tend to use EMAs and long-term traders tend to use SMAs for this reason.
Common Uses for Moving Averages
Traders use moving averages for many different reasons depending on their trading strategy and goals. For example, a day trader may use them as support and resistance levels whereas a swing trader may use them as building blocks for more complex technical indicators or trade setups.
A SMA as a support and resistance level.
Some of the most common uses include:
- Support and Resistance: Moving averages are common areas of support and resistance. For example, you may look at the 200-day moving average for a given stock and notice that the price always seems to react to it.
- Bullish or Bearish Bias: Moving averages represent longer term trends in price, so many traders use long-term moving averages to bias their short-term trades. If the 200-day moving average is rising, you may look for bullish trades in the short-term to stay with the trend.
- Confirmation: Moving averages can be used as confirmation for other technical indicators or patterns. For instance, you may be looking to buy after a RSI reading falls below 30 and use a short-term bullish moving average crossover as a confirmation of a bullish reversal.
- Building Blocks: Moving averages form the basis for many other technical indicators, including the popular MACD, and trading strategies, such as the moving average crossover.
Building a Trading System
Moving averages are commonly used to build trading systems and strategies. Often times, the biggest challenge is finding the right settings for the moving average — or the number of periods and type of moving average — for a given security. Different securities react differently to different settings.
TrendSpider makes it easy to backtest individual securities to see what moving average settings work best. Once you’ve found an ideal setting, you can setup real-time SMS and/or email alerts to notify you of opportunities.
TrendSpider’s backtesting and alerting capabilities.
The three most common trading strategies include:
- Crossover Strategy: A short-term and long-term moving average are plotted on the same chart. When the short-term moving average crosses above the long-term moving average, a buy signal is generated as a new bullish trend forms. When the short-term moving average crosses below the long-term moving average, a sell signal is generated as a new bearish trend forms.
- Bounce Strategy: The bounce strategy involves finding a moving average where the price tends to rebound from over time. For instance, a stock may consistently rebound higher from the 200-day moving average, which creates a buy signal whenever the price approaches it.
- Moving Average Envelopes: Moving average envelopes are created by adding five or more equally-spaced moving averages to the same chart. This creates a ribbon that can help predict when price reversals are likely to occur.
It’s important to backtest trading systems to ensure that they generate repeatable results. After achieving some success in backtesting, you may want to paper trade the strategy to ensure that you can generate consistent results in real-time. You can then use the strategy in live trading with confidence.
The Bottom Line
Moving averages are often dismissed by expert traders, but they can be powerful tools for traders at any level. They can also be added to other technical indicators to create robust trading systems that generate repeatable results.
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