I’ve been trading for about twelve years. I’ve tried a ton of indicators. The moving averages are the only indicators I use. And the reason is they’re reliable, and I trust them. And you won’t find much reliability in the markets.
Moving averages (MA) are one of the most important technical indicators. MA’s are excellent at smoothing out price volatility and clearly defining the market trend. Many top technical analysts use several moving averages (MA) simultaneously. Opportunities are identified by observing how price interacts with the MAs and also how the MAs interact with each other.
In this post, you’ll learn what the moving averages do and how they do it. You’ll learn the three main types of moving averages, and you’ll also understand how I use them to time entry and exit the markets.
What Do Moving Averages Do?
Market prices for some stocks, commodities, or currencies can be volatile. Wild fluctuations mean the trend is not always clear. This type of chart may be described as noisy. To help make sense of all this noise, analysts commonly use the Simple moving average (SMA).
The MA takes a sample of the same data but makes it smooth. It removes the volatile gyrations. This renders the MA useful as it offers a ton of information and opportunity, especially when combined with price.
- First off the MA direction and angle conveys the overall trend of the market.
- Where the price is relative to the MA (above or below) conveys the short term trend.
- How price interacts with the MA offers potential trade signal opportunities.
It’s not uncommon for analysts to combine two or more moving averages. The combination of a second or third MA allows the analysts to see a longer-term trend in play. This helps build a mental model of where the smaller trends and prices are in relation to the big picture.
How Do Moving Averages Work?
The moving average is as its name suggests. It’s an average of the price over x number of seconds, minutes, hours, days, months, or even years. The calculation is simple and, while uninteresting, is still worth knowing how the moving average is derived.
Take a moving average of 15. That’s a measurement of price, a snapshot if you like, every period. What’s a period? It’s whatever chart duration you’re watching. I say you’re watching the price on a 1-hour chart. The moving average is snapshotting price every hour on the hour for the last 15 hours.
Those prices are totaled and divided by 15. The result is a price that represents a dot on the chart. When we move into the 16 hours, the first hour is removed and 16th hour added, and so on.
Now it’s a matter of joining the dots.
Common Types Of Moving Average
There are three common types of moving averages. Charting packages include them all and allow the user to adapt them to suit. Below you’ll find a brief description of each and how they differ.
- Simple Moving Average (SMA)
- Weighted Moving Average (WMA)
- Exponential Moving Average (EMA)
Simple Moving Average (SMA) – It’s plain vanilla moving average. It takes an average of the previous x periods. It’s an equal-weighted average, meaning the first and last data points are treated as of equal importance.
Weighted Moving Average (WMA) – Simple moving averages are excellent, but they do have a weak link. They lag the share price. It takes time for the “average” to be represented by a change in the direction of the MA.
The Weighted moving average addresses this issue by giving more relevance to the most recent data. This is achieved by multiplying each of the periods by a progressive multiplier. The result is a MA that gives more relevance to the most recent data points.
The weighted moving average is like a purebred racehorse. It’s sensitive! Finding that sweet spot can be a challenge.
Exponential Moving Average – The EMA is not unlike the WMA in that it gives greater importance to more recent prices. And just like the WMA, it’s a sensitive animal. It differs from the plain vanilla WMA in that the multiplier is not applied consistently or proportionally.
The EMA is favored by most charters as it adapts quickly to a change in trend.
Choosing A Moving Average
The goal of all MA’s is to help represent the price trend clearly. A noisy MA is scarcely better than the price at representing the trend.
When choosing an MA, it’s important to find one that fits the price. What do I mean? You may find, for example, a 21 MA on the daily chart fits one stock sector perfectly. Price caresses the MA beautifully. However, switching to a different stock sector, you may find the MA simply useless.
It’s a matter of finding the best fitting MA(s) for your chart. When the correct MA is applied to a chart, the price will interact with the MA, respecting it, and when eventually crossing it, the price will retest the MA line.
Typical MA’s include:
- 12
- 21
- 26
- 50
- 100
- 200
Common MA pairings include:
- 13 & 21
- 50 & 200
Reading A Moving Average
You are already familiar with moving averages, and so you likely know how to read them. However, you may find some of the following techniques unfamiliar. The concepts are straightforward and see examples of each below.
- Price MA cross
- MA crossover
- MA trendline cross
- MA divergence
- MA peak/trough trendline
The MA is a super helpful indicator, and although lagging, it still contains a ton of market clues.
Price MA cross – A trend change is identified by price crossing the moving average line. This is a basic principle. However, this other information is available here too. When the price centers on the MA and fails to move, it’s said to be in equilibrium.
MA crossover – The 50 and 200-period pairing are tightly watched pairs. A cross lower of the 200 by the 50 day period signifies a bear market (A death cross). The 50 crossing upwards marks a bullish market (Golden cross).
MA trendline cross – A trendline drawn across the peaks and troughs of the trendlines. When the trendline is breached, it signifies a bearish market. In addition, the MA trendline extended into the future often offers support or resistance.
MA divergence – Divergence occurs when the price makes a new low, but the MA doesn’t. This is a possible clue that the price may be nearing the end of its current trend.
MA peak/trough trendline – MA peaks and troughs often offer resistance and support areas into the future.
How I Use Moving Averages
The moving average plays an important role in my trade decisions. First off, the MA is great at showing the current trend. I check the MA’s in relation to each other and tell me if the market is trending in the direction of my intended trade. I.e., if the 34 is above the 55 and 55 above the 200, basic stuff.
Checking where the price is in relation to the MA tells me about the mood of the market right now. Is price above or below the MA.
I check for MA divergence, finding divergence often signals a slowing of the current trend and the imminent change in direction.
Divergence occurs when, for example, in a down market, the price makes lower lows, but the MA(s) is forming higher lows. This often points to a market that is running out of downward pressure and is preparing to turn higher.
Previous Ma peaks and troughs offer resistance and support. I extend horizontal trend lines from previous MA peaks and troughs. Often you’ll find price stumbles at these price points. A stumble can turn into a reversal if there are additional resistance factors at play.
Trade Setup
I don’t trade the technicals exclusively. I developed a top-down approach, using the fundamentals and then the technicals to find entries and exits. I trade forex short and medium-term, and I invest in stock for the long haul.
I use candlestick charts and EMA’s, the 34, 55, and 200. I use these because they fit my style of trading, and they fit my charts.
I use the MA’s in conjunction with:
- Price points
- Trendlines
- Candlestick shapes
The strategy you are about to learn is easy, looks too easy, but know that it took me years to hone. I appreciate it may not work for everybody. We’re all different and have different trading and investment styles.
Note also, this is important. I don’t trade the technicals in isolation.
I run the fundamentals first before I open a chart. I know the trade direction I want, rightly or wrongly. The technicals helped me find the entry point. I don’t pick a market direction based on technicals.
Here’s how I implement the technicals and, in particular, how I use moving averages.
Price point – Markets are people, and they love whole numbers. So I go ahead and mark a horizontal line at the whole numbers close to the price action. I’ll also mark the half numbers if applicable. See chart. Watching how the price reacts around these numbers often presents an opportunity.
Trendlines – I mark up the charts with the most dominant trend lines. I use long-pin candles as the pivots. They are important. Extending out old trendlines often presents trading opportunities as they offer support and resistance.
Candlestick shape – I pay attention to three candles and one in particular. The long tail candle develops after a struggle between buyers and sellers. The losing side loses by lack of numbers. The long tail, therefore, signifies a vacuum is present in the market, and that often means a reversal has begun.
In summary, I consider entering a trade when a long tail pin develops after the price reaches an MA, which also occurs at a whole number (or half) and is supported/restrained by a trendline.
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