Moving Averages

Moving averages (MAs) are the indicators mostly used in technical analysis and represent an instrument that smooth out the noise in the price in order to mitigate wrong buy/sell signals. This indicator is also called trend-following or lagging because it is based on past price information.

The most commonly used MAs are the simple moving average (SMA), which is just the average price of a security over a defined time period, and the exponential moving average (EMA), which gives greater weight to more recent prices.

Even though there are clear differences between simple moving averages and exponential moving averages, one is not necessarily better than the other. Exponential moving averages have less lag and are therefore more sensitive to recent prices - and recent price changes. Exponential moving averages will turn before simple moving averages and therefore one can consider them more for shorter time frames and fast-moving markets. Simple moving averages, on the other hand, represent a true average of prices for the entire time period. As such, simple moving averages may be better suited to identify support or resistance levels and smooth out unnecessary noise in the price for longer term positions.

The length of moving averages depends on the analytical objective of the trader. Generally, the most popular moving averages are 20 day (for short term), 50 day (for medium term) and 200 day (for longer term). Many analysts plot these three averages all together in order to have a clearer picture of the trend and anticipate both short and long-term volatility in the trade.

How does it work?

A rising moving average indicates that a security is in an uptrend, while a declining moving average indicates that it is in a downtrend.

Moving averages can also act as support, in an uptrend, and resistance, in a downtrend.

A buy signal is generated when the price crosses and closes above the moving average whilst a sell signal is generated when the price crosses and closes below the moving average.

Another buy signal is generated when a short term SMA (e.g. 50 day) crosses above a longer term SMA (e.g. 200 day). This is called a golden cross.

Whilst Another sell signal is generated when a short term SMA crosses below a longer term SMA. This is called a death cross.

The below chart shows a couple of examples for these crossings.

 

Things to remember:

  • A shorter moving average will react quickly to change in prices but longer moving averages tend to be more reliable.
  • When a price crosses a moving average, it is known as single moving average crossing
  • When a moving average crosses another moving average, this is known as multiple moving average crossing. This is considered as the most powerful to provide a trend.