Trading Knowledge

Expand the knowledge of trading, improve the level of trade, let you trade confidently, in the series of educational articles provided by Pacific Union.

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Moving Averages
A moving average is a type of technical indicator that traders use in order to calculate the average price of a security over a given time.

There are two different types of moving averages; simple moving average [SMA] and an exponential moving average [EMA]

Simple Moving Averages (SMAs)
A simple moving average is calculated by adding up the last “X” period’s closing prices and then dividing that number by X. 

If you plotted a 10 period simple moving average on a 1 hour chart, you would add up the closing prices for the last 10 hours, and then divide that number by 10.  There you have a simple moving average.

A simple moving average shows us the overall sentiment of the market at a point in time. It helps to show market direction by smoothing out market noise (price fluctuations) over time and can also be used to identify support and resistance as well as generating buy/sell signals.

We can see here that the longer the SMA period is the more it lags behind the current price; i.e. the higher the number period you use the slower it is to react to a current price movement.

One problem that traders often experience with SMAs is that they are very susceptible to price spikes.

Exponential Moving Averages (EMAs)
EMAs place more weight on the most recent periods and react faster to recent prices than SMAs. The shorter the EMA period the higher the weight that the current price will carry in the MA curve – the opposite is also true.

SMAs or EMAs
Now that you know the difference between simple and exponential moving averages you’re probably asking yourself when you would use them and more importantly, which one is better.

The answer is – either; it may sound cliché but, like most methods of analysis, it really depends on your trading style.

Let’s go through the pros and cons of both SMAs and EMAs to help you work out which falls in line better with your trading strategy.

EMAs respond faster to price movements and help you catch recent trends faster and more accurately than simple moving averages.

BUT
EMAs react SO quickly to price movements that often a price spike can be misinterpreted as the beginning stages of a trend.

SMAs are better when you are looking at a more long term and general movement of the market. It is best applied to trends over longer periods of time and avoids the misleading price spikes encountered when using EMAs.

BUT
Although beneficial when taking a long term view, the slow reaction experienced when using SMAs causes a price lag which can make short term movements harder to take advantage of.

Now that we have compared the two, it’s really up to you to decide which you would like to use. Take into consideration whether you are looking to gauge a long term trend, or looking to take advantage of a short term movement.

If you’re ever in doubt which to use, there’s no harm in using both; EMA to get a general idea of the overall trend, and SMA to take advantage of short term movements.

How to use moving averages
Moving averages are used to facilitate lots of trading strategies such as;

  • Identifying trends and reversals
  • Measuring the strength of market’s momentum
  • Recognising support and resistance levels
  • Spotting potential entry and exit points

Identifying trends
As mentioned before, moving averages are lagging indicators; they do not predict new trends, but confirm trends once they have started.

Moving averages are often used to identify trends as displayed in the graph above. When the price of the product is higher than that of the moving average then the price can be said to be in an uptrend.  For example many traders will only consider going long when the price is trading above a moving average.

The opposite is also true; in instances where there is a downward slope with the graph displaying prices lower than the moving average traders will use this to confirm a downtrend.

Identifying momentum with Moving Averages
The strength and direction of a market’s momentum can also be assessed by the use of moving averages.

On the graph below three moving averages have been applied;
Blue – EMA50 [short term]
Pink – EMA100 [medium term]
Orange – EMA200 [long term]

The three moving averages used here have varying time frames in an attempt to represent short-term, medium-term and long-term price movements.

In this graph an upward momentum can be seen in instances where the shorter-term averages are located above longer-term averages.

When the shorter-term averages are located below the longer-term averages, the momentum is in the downward direction.

Finding Support and Resistance with Moving Averages
The falling price of a market can stop and reverse direction at the same level as an important average.  This means that moving averages can often be used to identify support and resistance levels on a chart.

An example can be seen in the graph below when the 200-day moving average can be seen to have provided a support level.

Moving averages that are based on longer time periods will give you a stronger and reliable view of a support level than shorter time frames.

In cases where the price falls below an important moving average it can then act as a resistance level which traders often use as a sign to take profits or to close out any existing long positions.

Traders also use these averages as entry points to go short because the price often bounces off the resistance and continues its move lower.

Finding crossovers with Moving Averages
Moving Averages can be used to generate buy and sell signals by identifying when an uptrend or downtrend is starting

As we discussed previously moving averages can be used to define up and downtrends. Moving averages can also therefore be used as a signal to buy or sell.

A cross above a moving average can be a signal to go long or close out a short position.

A cross below a moving average can be a signal to go short or close out a long position.

The most common type of crossover is when the price moves from one side of a moving average and closes on the other – this can be seen on the graph below.

Blue – EMA20 [short term]
Pink – EMA100 [long term]

When a short-term average crosses through a long-term average it can mean momentum is shifting in one direction and that a strong move is approaching.

A buy signal is when the short-term average crosses above the long-term average.

A sell signal is when a short-term average crosses below a long-term average.

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