Moving Average: what do you need to know?

Moving average is the most widely used indicator for trading that is considered as the most important among other instruments of technical analysis. Also, it is at the core of many other instruments that are used by traders. This is an easy-to-use instrument that is simple to understand for beginners. That’s why a lot of people use Moving Average as the first instrument for technical analysis. However, we can talk about different types of MAs and some aspects of implementing them in trading.

What is a Moving Average?

Moving Average has been used for a long time in different countries. It is the price of the currency pair or other instruments for trading that is average for a certain period of time. If we talk about Forex, this period of time is marked by a certain number of candlesticks or bars. 

For instance, let’s add a Moving Average with the setting on 8 candlesticks. We are going to make its color red. 

Moving Average: what do you need to know?

It demonstrates to us the average price for 8 candlesticks from the end. Naturally, after 8 candlesticks, it removes from calculations the 1st one and starts calculating from the 2n to the 9th. If we set a period on 21 instead of 8, the price will be calculated for 21 candlesticks. 

Therefore, we are able to understand the general direction that looks smoother and more clear if we want to compare it with the standard graph. 

In general, if the cost of financial instruments is placed above the indicator we consider, we say about an ascending trend. If it is placed lower, it is a downtrend. Simultaneously, with a period of MA 21, we can say that if the financial asset is placed above it on the graph, it has a significantly short ascending tendency. 

If the price on average is significantly greater, for example, 200, and the price is bigger compared to the moving average with a period of 200, we can say that the serious descending tendency takes place.

In different words, the longer the moving average is, the more imprecise it is. Why? It needs to get the average price for the candlesticks which have been created recently (in our case, 200). There are a lot of them. The longer period is, the higher value it has in the long-term perspective. 

There are several kinds of this indicator. When you add it to the graph, you need to move it higher or quite lower, make two moving averages and create a channel. But usually, this shifting is used relatively not so often. We can then choose the part of the candlestick that we are able to apply the moving average to. By default, the average closing price is taken into account. 

We can also calculate the average opening price, middle point, high (the highest point of a candlestick), and the lowest one – low. Also, we can get SMA from other points. Moreover, we can choose different options that can help us trade effectively.

Exponential moving average

On the graph above, we demonstrated a simple type. Other technical indicators usually take into account both of these types of moving averages. Also, other indicators can use the principle of forming MAs for generating unique graphs. For example, some oscillators do that.

Let’s insert into the graph an exponential MA with a period that is lower than the previous, for example, 21. We will make it red in our example.

To compare them, let’s make an SMA blue with the period that is the same as the previous. So, SMA is blue with a period of 21 candlesticks and EMA is red with the same period. What’s the difference? Look at the graph.

Moving Average: what do you need to know?

The exponential moving average attaches great importance to the most relevant data. In our case, it assigns values from the last bar in descending order. 

The last bar is very important. Next, up to 1 of 21 bars, the importance becomes lower, and the middle EMA becomes sensitive. 

It is the most sensitive on the last bar and the least sensitive on the first bar (depending on the settings). 

SMA assigns the same values for all the bars or candlesticks. That’s why the exponential kind of indicator reacts to the changes faster compared to the SMA. It is a significant reason why it is used more often. Usually, for short periods, the exponential kind is used. 

Why do you need simple moving at all? For example, it shows great results for longer periods (200, 265).

Weighted moving average

This type is very rare, but you need to know about it. It can be used in some strategies. Let’s add one more MA. At this time, it will be weighted. 

What is the difference between SMA and WMA? So to speak, it is the second version of the exponential moving average. It distributes the significance of bars differently. But the last bar is still the most important compared to others. 

For instance, the last bar is 4n, the penultimate is 2n, the next is n and the following is n/2. It is sharper and more dependent on price fluctuations. That’s why it isn’t as widely spread as the usual exponential moving average. 

Smoothed

Let’s make it golden on our graph. It looks like it has a longer period. 

Moving Average: what do you need to know?

What’re the reasons? The smoothed line is placed between SMA and EMA. At that time, if the SMA takes into account a period of time that we set (in our case, 21 candlesticks), smoothed moving also considers previous bars but with a lower weight coefficient. That’s why a graph becomes smoother, and it is great for detecting long-term trends. Therefore, you’d better set a longer period. 

We can draw a conclusion that the smoothed MA automatically increases the period that we set in the settings. Thus, it turns out to be more fixed compared to other types of moving averages. But it is rarely used.

What kind should you use?

Really, the exponential MA is the most popular type of this indicator. If we talk about longer periods, you’d better use a simple moving average. Other kinds exist but you may not use them. 

You should understand that the longer period there is, the less flexibility there is. Therefore, its signals are more important if the cost crosses it. 

What period are you supposed to use? The common option is short MAs with periods of 8 and 21 candlesticks. If we talk about long averages, the perfect options are 150, 365, 200. 

You’d better remember that the longer period is, the less flexible it is and the bigger price movement needs to be to change the direction of the movement of this indicator. 

How can we use MAs in trading?

We can hear the term ‘crossing’ in the classical books about trading the most often. When fast MA (with a shorter period) crosses the longer, from button to top, it means a need to buy a purchase order. 

Vice versa, if the fast MA breaks slow MA from top to the bottom, it is a signal to open an order in the direction of falling price.

However, it is common when traders decide not to use the signal. It is especially important when it is a flat on a market. Since the market became less trendy, there were a lot of false signals. We can consider that as a confirmation of the logic of how our trend is found. 

We look at our graph and check what’s the trend now. First, our long-term MA was moving upper and in a certain place, a movement below was started. We look at how moving averages were crossed some time ago, and we can say that now it is a descending trend. 

Crossing of moving averages can be considered as an additional filter for detecting the stable direction of the price movement, but you need to use other signals as well. Also, you need to take into account a tilt angle. The sharper it is, the bigger power the trend has. Therefore, it can be applied to moving averages on big timeframes (20 minutes and more). 

As you can see on the graph, in some cases price moves to the SMA or EMA, tests them and returns back in the direction of the existing trend. That’s why we can consider moving averages as dynamical support or resistance levels. If a signal was created from a line with a period of 89, we can use the fact as a signal to open a position. 

If there isn’t any important level not far from the price, but we have a moving average with the period of more than 20, we can consider it as an important level if we have an additional signal that can confirm this.

You can set stop losses outside the moving average and move it as we get closer to the price. Moving averages can be used as a signal for closing some positions. Crossing of the moving averages isn’t a great signal for opening new orders without additional instruments. However,  if you want to close an order, it is a great idea to use this signal. If you have long-term orders, you’d better close an order after crossing short moving averages. 

Wrapping up

Today, we haven’t said anything about formulas that can be used for calculating different types of moving averages. Why? Because an average trader doesn’t need to have formulas for building indicators now. This process is totally automated. 

You don’t need to understand how a TV or microwave works to use it. We can say the same about trading indicators. You just need to add them to your graph. 

You’d better use different technical indicators because each of them is suitable for a certain situation. Some signals were effective previously but they aren’t effective now. Also, you need to connect technical analysis with fundamentals to improve your results. 

Yes, I want access to free training

Written by:

author

Carolyn Huntington is an economist, professional trader, and analyst. She made her first big deal in her student years with a profitable investment in Facebook stock. Now the total experience of her trade is 18 years. Over the years of trading, Carolyn has developed its own strategy that allows even those who have never traded on the stock exchange before to earn money. She also creates market forecasts and advises major shareholders, compiles investment portfolios, and teaches how to work with automated advisors.

telephone: 503-547-5192