The moving average is a commonly used indicator for opening/closing positions and identifying market conditions.
What is a Moving Average?
A moving average is an indicator that shows the average price of an asset over a specific period. It is represented as a line on a chart. To calculate a moving average, you need to take the average price over several time periods. The moving average is plotted on the chart, and the closing price of each candlestick is often used to construct it.
A moving average represents the average price of an asset over a certain period.
It’s used to smooth out price movements, providing a line that can make market information easier to decipher, such as trend direction.
Traders can also use the moving average to understand which direction they should trade in. This will depend on whether the price is below or above the moving average.
If the price is above the moving average, it’s above the average value over the recent period, which may indicate a price increase. Conversely, if the price is below, it can be perceived as a price drop.
These evaluations are subjective as each moving average relates to a period when you are monitoring the trend. Therefore, the moving averages that will appear in the future should also be considered when making a decision.
For instance, if the price is trading above a 20-period moving average, you may interpret this as the price being in an upward trend. However, the price might be below a 200-period moving average, indicating a long-term downward trend.
Each trader can use these moving averages to identify both current short-term and overall long-term trends.
Using Moving Averages to Determine the Trend
By using multiple moving averages, a trader can pinpoint precise uptrends and downtrends.
If there is a trend in the market, the moving averages will align in the order of their lengths from the current price. When moving averages are ordered, it’s much easier to discern the trend. Multiple moving averages can help accurately identify downtrends and uptrends.
Choosing the Period
There’s no precise rule that determines how many periods a trader should use for a moving average. The choice will be individual.
The fewer periods for a moving average, the quicker it will adjust to price changes, but it may not provide as accurate signals as a longer-term average. Conversely, a longer period will give more accurate signals but will not respond as quickly to price changes.
For example, a 10-period moving average captures the last ten periods and thus responds more rapidly to price changes. Its drawback is the frequent false signals regarding trend changes, due to short-term price spikes.
However, a 200-period moving average will not react as quickly to price changes and won’t give false signals as frequently. Its downside is the low frequency of these signals.
Types
There are four main types of moving averages:
- Exponential
- Simple
- Linear Weighted
- Smoothed Weighted
The primary difference between these types lies in their calculation method. Hence, they are displayed differently on the chart.
Simple moving averages give equal weight to each period. Exponential, linear weighted, and smoothed weighted increase the influence of the latest periods.
You don’t need to calculate each type of moving average manually. Any charting software will do this automatically, and you only need to use the lines depicted on the charts.
Using Moving Averages as Support and Resistance Levels
Moving averages can also be used as support and resistance levels for entry and exit points in the market. This means that when the price on a chart reaches a moving average, traders watching it will place sell or buy orders. This principle is the same as with horizontal support and resistance lines.
When the price on the chart touches the moving average, it can be a resistance level if the price reaches it from below. If it comes from above, it can be a support level.
Moving averages are dynamic support and resistance levels as they change when the price changes.
Crossing of Moving Averages
Crossovers can be used to identify a change in trend direction. You need to apply two moving averages with different periods, which should represent long-term and short-term trends.
During a crossover of the long-term trend’s moving average from below to above, there may be a signal indicating a change to an upward trend. Similarly, a crossover of the long-term trend’s moving average from above to below can signal a change to a downward trend.
When traders see this, they can use this information to pinpoint the exact time to enter or exit the market.