A moving average is a smoothing mechanism that helps to identify the price trend over a given period of time. This is considered a lagging indicator because it is generated using past prices. Technicians use this indicator for a variety of strategies and signals. Additionally, there are a variety of settings that can be applied to this indicator to produce the desired effect appropriate for the strategy being employed. Lastly, moving averages are an important component of a variety of indicators and oscillators including the popular momentum indicator, moving average comvergence divergence (MACD).
Most moving averages are based on the closing prices of whatever time period the chart you are looking at, whether it be daily, weekly, monthly or intraday time-frames. The most common periods used for moving averages are the 50, 150, and 200 period moving averages. Other popular periods used include the 8, 21, 55 and 144 period moving averages due to their significance as fibonacci numbers. None of these settings are inherently correct or better than others so it really is a matter of preference.
2. Simple / Weighted / Exponential:
A simple moving average (SMA) is also known as the arithmetic average and is a common average of the price values in the specified period. Each price in the series is equally weighted.
A weighted moving average (WMA) assigns a weighting factor to each value in the data series according to its age. The most recent data gets the greatest weight and each price value gets a smaller weight as we count backward in the series.
An exponential moving average (EMA) is calculated in a way to give more weight to the recent prices in an attempt to make the smoothing mechanism more responsive to new information. As we count backwards in the series of prices in the period, each one is assigned an exponentially smaller weighting in the calculation, hence giving more recent prices more weight.
The benefit, and potential drawdown, of a weighted moving average is that more signals are generated because the moving average follows price more closely. That can help because there is less of a lag but there may be a lot of false signals generated because of the increase in amount of crossovers and slope changes.
1. Slope of the Moving Average:
If the moving average is sloping higher, the trend is higher.
If the moving average is flat, there is no current trend. This may be a consolidation of the prior trend or the start of a trend reversal.
If the moving average is sloping lower, the trend is lower.
2. Moving Average Crossovers
Traders often use moving average crossovers as buy or sell signals. When a moving average of a shorter period crosses above or below that of a longer period, it may be the signal of a new trend emerging. For example, the golden cross is when the 50 day moving average crosses above the 200 day moving average, signaling that the trend in price is now higher. On the flip-side, the death cross is when the 50 day moving average crosses below the 200 day moving average, signaling that the trend in price is now lower.
Crossovers are helpful in determining the overall trend, but it is important to remember that moving averages are lagging indicators. Strategies based on crossovers are likely to catch the middle of the trend, but give back some of the gains at the tops and bottoms of trends.
3. Support / Resistance
In addition to helping technicians identify the price trend, moving averages may also act as support and resistance. In certain circumstances a particular moving average may prove to be a significant price level when analyzing a security.
The slope of a moving average can also provide important information about the momentum present in the security being analyzed. By plotting short term, medium term, and long term moving averages on one chart you can see whether or not the majority of them are moving in the same direction. If they are all confirming a trend in the same direction, momentum is moving in that direction as well. For example, if the 20 day, 50 day, and 200 day simple moving averages are all sloping and trending lower, momentum is clearly favoring the downside.
5. Moving Average Seperation:
When a short term moving average gets too far extended from a long term moving average it may signal that the current trend is unsustainable and that price needs to consolidate. For example, if the 50 day simple moving average is 20% higher than the 200 day simple moving average, it may signal that price has become too extended to the upside and needs to pull back or consolidate to allow the longer term moving average to catch up. This is often referred to as a reversion to the mean, or average for the period being studied.