Moving Averages: What Are They?
Moving Averages are technical tools designed to measure the momentum and direction of a trend. The idea behind their creation is simple. Price action is thought to fluctuate around the average value over a period of time, and we can expect to be able to the represent the market's momentum by calculating if the current prices are above or below the market's average value. But since the total length of the time period that must be included in the calculation of the average is too large (are we going to begin in 1980, or the year 2000 while computing our time series?), we pick the period arbitrarily, and update the average as time progresses.
Why Should I Use Moving Averages?
Moving averages are some of the most useful and effective gauges of market action in a trending market. Crossovers, divergences, as well as trends of the moving average itself can be used to analyze and crystallize the signals that can be distilled from the market action, which can then be used to help us make future decisions about our trades.
Types of Moving Averages
There are a large number of moving averages available for traders. Some of them are:
Simple Moving Average
The simple moving average is the most basic of these tools. It simply sums up the cloaisng prices over a specified time, and divides them by the duration of the period, reaching at the value of the indicator. No weighting is used, and no smoothing factor is applied.
Exponential Moving Average
The exponential moving average is one of a number of different moving average types that gives greater value to the most recent prices. As its name implies, the weighting is done exponentially. In other words, as we move to the left on the chart (towards past values), the weighting that they receive in the computation of the MA decreases rapidly (faster than it would be in a linear progression), and the most recent prices are far more significant, as a result, in determining the value of the indicator.
Smoothed Moving Averaged
The smoothed moving average is similar to EMA, except that it takes all available data into account. The earliest price values are never discarded, but receive a lower weighting, and possess a smaller role in determining the value of the indicator. As its name hints, the smoothed moving average is mostly used to smoothen the price action, removing short-term volatility, allowing us a better understanding of the long term momentum of the market.
Linear Regressed Moving Average
This moving average is similar to the MA, except that the weighting factors are linear, not exponential. For example, the price of the earliest period (n) is multiplied with 1, the following, more recent period (n-1) is multiplied by a factor of, 2, and the next one is multiplied by 3, and so on, until we reach the present timeframe. In this context, the most recent prices receive greater emphasis, and the latest fluctuations, rises or falls are depicted with greater clarity, aiding trade decisions.
Using the Moving Averages
Although there are almost countless improvised, and professionally created strategies based on moving averages, there are three typical methods that lie at the basis of most of the strategies and methods.
Crossovers arise when the price rises or falls below the moving average, signaling the end or the beginning of a new trend. Crossovers are some of the most common occurrences in technical trading, and as such, do not grant us a great deal of predictive power in the evaluation of the market action. They are used best in combination with other tools and techniques when we seek to evaluate the price action with greater confidence.
Moving Average Trends
Apart from trends in the price action itself, the moving average can also have its own trend at times. It is possible to take advantage of these trends for determining entry/exit points. Although not as reliable as the price trend itself when used alone, it can be an efficient way to confirm the price action when used in combination with it.
A divergence occurs when the trend is in ascendance, but the moving average is descending. A convergence happens when the market trend is bearish, but the moving average contradicts it by registering higher highs. These events are thought to signal a future reversal. When the price action is contradicted by the indicator values, the expectation is that the market is about to run out of energy, and it may be a good time to open a counter-trend position. It is important to remember that timing is very uncertain in all these formations, and that the anticipated reversal may never occur. Especially in strong trends, it is common to observe divergence/convergence phenomenon arise regularly without leading to any significant reversal. Still, it is the rarest, and most popular technical configuration preferred in the interpretation of a moving average.
We use this term to define a method of trading in which MAs of different periods are used as successive resistance levels for the price action to breach. For example, we expect an ongoing trend to first breach the 1-hour, then the 3-hour, then the 10, and 40-hour moving averages in succession, and may choose to open a position at each of these successive indicators. Since we anticipate continuity between levels indicated by these MAs, we will maintain our positions as the price hops, so to speak, between them.
We'll examine each of these methods as we discuss each moving average type in its own article. To learn more about how these calculations are performed you are invited to visit the relevant page.
The main weakness of the moving average is its lagged nature. In many cases, and especially for short term fluctuations, by the time a moving average captures a market event, it may have already ended. The moving average will only note a developing market pattern after it has been set up convincingly, and if the pattern is short-lived, it will not be possible to trade it, and we may suffer from whipsaws as well.
The strength of this indicator type is its ease-of-use, clarity, and simplicity. They can be easily incorporated into any overall strategy, and it is also possible to devise methods exclusively through the usage of the moving average as well. The great versatility of this indicator type makes it a valuable addition to any trader's arsenal of technical tools, regardless of trading style, or the preferred market type.