A moving average is a tool that helps traders determine the direction of the current trend, as well as providing guidance on possible entry and exit points. Here we discuss the different types of moving averages there are, how best to use them, and what caution should be used when factoring them into your trading strategy.
What exactly is a moving average?
By combining price points, a moving average is able to lessen the impact of daily or hourly price movements that so often make the chart look disorderly and confusing. In doing so, the moving average is able to help traders better determine the direction of the current trend, as well as provide guidance on possible entry and exit points.
What are the different types of moving averages used by traders?
There are two commonly used moving averages: the simple and the exponential.
The simple moving average is calculated by taking the average of a given set of values. In other words, it is the product of adding together a certain number of prices and then dividing that by the number of prices in that set. For instance, in order to calculate a simple 10-day moving average, one would add together the closing prices of a particular stock over the last 10 days and then divide that number by 10.
The following is a simple 30-day moving average for AIM-listed video game developer, Frontier Developments. Looking at the chart you can see how the moving average follows the price but there is a lag due to the closing price for the previous 29 days being factored into the equation.
The exponential moving average, meanwhile, is a moving average that gives more weight to recent prices in an attempt to make it more responsive to new information. Below you can see how the exponential moving average (orange) and the simple moving average (blue) are slightly out of sync as a result.
Although most charting platforms will perform the calculation for you, the equation for the exponential moving average is the following (for anyone interested to know):
[Closing price-EMA (previous day)] x multiplier + EMA (previous day)
Which is better: a simple or an exponential moving average?
Deciding on which moving average to use depends entirely on your trading strategy.
There are those, typically short-term traders, who prefer the exponential moving average as it alerts them as soon as the price begins to move in another direction. However, there are also those, typically mid- to longer-term investors, who prefer the simple moving average as it provides more certainty that a trend is actually forming, rather than being influenced by short-term price fluctuation.
Ultimately, it comes down to personal preference and there’s certainly no harm in plotting both on the chart and seeing how they compare.
How long should your chosen moving average be?
The longer the time period, the greater the lag. For example, a 200-day moving average will have a much greater degree of lag than a 10-day moving average, meaning that the former will be a lot less reactive to a change in trend (as depicted below; 200-day moving average in black).
However, this doesn’t mean that the shorter moving average is always more favourable. By being much more reactive, moving averages with less data points can often lead traders to think a trend if forming when really it’s simply a price spike, resulting in them buying a fakeout instead of a breakout.
Generally, though, shorter-term moving averages, such as those with 10-20 periods, are better suited to shorter-term traders, whilst longer-term investors would generally opt for those with 50 or more data points.
What are moving averages best used for?
Quite simply: moving averages are there to help identify the trend and then recognise possible changes in that trend. Towards achieving this, there are several techniques commonly used.
Moving Average Crossover:
In terms of recognising a change in trend, a popular technique is to plot on a chart a slower and a faster moving average (one with more data points and one with less), and then identify points at which the faster moving average crosses through the slower.
For example, if a 10-day moving average crosses up through the 30-day moving average then that stock has the potential of changing from a downtrend to an uptrend. Conversely, if the 10-day moving average crosses down through the 30-day moving average then the stock has the potential of changing from an uptrend to a downtrend.
Looking at the highlighted crossovers above, SEE was trading sideways up until the end of April where it broke out into a strong uptrend, signposted by the 10-day moving average (dark blue) crossing up through the 30-day moving average (light blue). The next time these two lines met was in July where the 10-day moving average crossed under the 30-day moving average, which was towards the start of a strong downtrend. More recently, you can see that the 10-day moving average crossed momentarily above the 30-day moving average in October but almost instantaneously went back beneath the 30-day moving average. This just goes to show that moving averages are just a small part of technical analysis and need to be combined with other indicators to confirm the trend.
Trader Action Zone (TAZ):
Another technique that uses moving averages to identify possible entry and exit points is referred to as the Trader Action Zone. Again, using a faster and a slower moving average, this is a zone on a stock chart where traders can identify possible reversals in a stock.
For instance, looking at the chart below, the TAZ is the area in between the 10-day moving average and the 30-day moving average. This area is where traders – typically short- to medium-term traders – will look for possible reversals in price.
The reasoning behind using TAZ is that when on an up or downtrend the share price doesn’t ever go in a straight line. Instead, it has days, sometimes weeks, when it pullbacks against the trend. It is these moments that provide the best opportunity to buy the stock. For what reason? Basically, if you’re buying a stock then you want as many sellers out of the stock as possible before you get in. Alternatively, if you are shorting a stock, then you want as many buyers in the stock before you get in.
Looking again at the chart above, then, the first highlighted box would have made a good entry point if missing out on the initial breakout in late March. Conversely, if shorting the stock, then the second highlighted box would have made a good entry point, rather than getting in as soon as the price drops.
What other trading tips are there for using moving averages?
Moving averages only work when the stock is trending, meaning that it has entered an up or downtrend, rather than trading sideways or in a trading range. Reflecting this, there should be plenty of space between the moving averages when using a faster and a slower one to help identify possible entry or exit points.
Above all, though, it is important to remember that the moving average is a lagging indicator. This means that they follow price action, rather than predict it. Accordingly, they will always be one step behind. For example, just because the price has moved into the Trader Action Zone this doesn’t mean it will necessarily reverse back towards the trend, as it could in fact be the start of an opposing trend.
Moving averages should always be used in conjunction with a large number of other tools and techniques.
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