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A trader’s guide to moving averages
A popular technical indicator, the moving average can help you spot trends. Learn how to calculate the moving average and how you can use it in your trading.
Technical indicators can make a big difference while trading. Among the most popular strategies used to indicate emerging and common trends is calculating the moving average (MA). Put simply, the MA is the mathematical formula used to find averages, using data to find trends.
What is the moving average?
The MA is a technical indicator used by traders to spot emerging and common trends in markets. It is a mathematical formula used to find averages by using data to find trends and smooth out price action by filtering out ‘noise’ from random fluctuations.
In stock market analysis, a 50 or 200-day moving average is most commonly used to see trends in the stock market and indicate where stocks are headed. The MA is used in trading as a simple technical analysis tool that helps determine price data by customising average price. There are many advantages in using a moving average in trading that can be tailored to any time frame. Depending on what information you want to find out, there are different types of moving averages to use.
A moving average can be used to provide support in an uptrend, the average can act as a base ground or ‘support’. In a downtrend, a moving average can act as resistance, or a ‘ceiling’.
How to calculate moving average
The MA is the calculated average of any subset of numbers, using a technique to get an overall idea of the trends in a data set. Once you understand the MA formula, you can start to calculate any subsets to get your MA. It can be calculated for any period of time, making it extremely useful to forecast both long and short-term trends.
To calculate the MA, you simply add up the set of numbers and divide by the total number of values in the set. For example, if you wanted to calculate the moving average of a five-year period, you would add up the numbers over that period, and then divide by five.
The moving average is very similar to finding the ‘middling’ value of a set of numbers, the difference being that the average is calculated several times for several subsets of data.
How do traders use moving averages?
Using MAs can be fundamental for technical analysis strategies, and using a combination of techniques can result in long and short-term forecasts. MAs can be calculated manually and used in any chart analysis simply by following the formula.
As discussed above, MAs can be used to determine levels of support and resistance. IG charts feature MAs, as well as other technical tools like Bollinger bands and relative strength index (RSI), in order to help traders with technical analysis. It can be used by clicking the ‘technical’ tab at the top of the chart.
It’s also important to note that there are two main types of MAs; exponential moving averages (EMA) and simple moving averages (SMA).
Exponential moving average
The EMA is calculated by placing greater weight on the most recent data points. It can sometimes be referred to as the exponentially ‘weighted’ moving average. This is because EMAs react significantly to the most recent price changes.
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The most popular EMAs are 12 and 26-day EMAs for short-term averages, whereas the 50 and 200-day EMAs are used as long-term trend indicators. When used in conjunction with other indicators, EMAs can help traders confirm significant market moves and gauge their legitimacy.
Simple moving average (SMA)
The SMA formula is calculated by taking the average closing price of a security over any period desired. To calculate a moving average formula, the total closing price is divided by the number of periods.
For example, if the last five closing prices are:
28.93+28.48 +28.44+28.91+28.48 = 143.24
The five-day SMA is: 142.24/5= 28.65.
SMA vs EMA
Both the SMA and the EMA are commonly used formulas. The two are very similar, but have a significant point of difference; the sensitivity each one shows to changes in data. The EMA gives a higher significance to recent prices, while the SMA gives significance to all values.
Both are used in technical analysis and can be interpreted in the same manner to even out price variations.
While some might argue it is more common to see the SMA used by technical analysts, others might say that using EMAs can be more significant to analysis because of their nature and the significance they give to recent data. EMAs tend to be timelier and therefore can be favoured by some analysts, also tending to respond to price changes faster than SMAs.
How to trade using moving averages
Using MAs while trading can help identify trends and become significant in building trading strategies. If price action is above a moving average it can be indicative of long positions, while if the price action is below the moving average, it can be an indication that short positions should be taken.
Traders can also use the moving average crossover method as a trigger into new positions. This method is one that is commonly used in trading strategies.
Day trading using moving averages
Using MAs for day trading can be extremely beneficial. It can be a clean and simple way to understand when a stock is trending and to analyse the market. Day traders would benefit from using MAs because they need to make quick decisions without having to do complicated calculations – often they’re required to make decisions within short periods of time, making the MA formulas a common go-to for day traders.
MAs can provide a simple yet effective way to know what side of the market you should be trading that day. If it’s trading below the moving average point, then this can be a clear indicator to take the short position. While using MAs can be useful, it is important to note that nothing in financial markets is for certain when using technical indicators, and things can change quickly. While MAs can be helpful and provide great analysis, they’re not a magic formula that can predict which way to trade.
If you think of MAs as a useful tool, used in conjunction with other indicators, they can provide useful information to aid in your day-to-day trading decisions.
Moving average trading strategies
The use of multiple moving averages will typically enable a more powerful trading strategy. The three examples below are examples of moving average trading strategies that utilise multiple averages.
Trend trading with multiple averages
A market that is highly trending will typically show an element of order in relation to moving averages. The chart below highlights that for an upwardly trending market, we should see the price trade below the short-term SMA, with the medium and then long-term averages above that. This would be inverted for a downtrend.
When a market displays this form of orderly characteristic, it allows for a trending market following trading strategy. Buying (uptrend) or selling (downtrend) at the nearest moving average would then allow for traders to find entry points within this highly trending market.
The EUR/GBP chart below highlights this technique, with the price turning back onto the bearish trend from the lower (20) SMA on a number of occasions. The push through the highest moving average (200) provided a signal that this trend is over.
The moving average crossover method is one of the most commonly used trading strategies, with a shorter-term SMA breaking through a longer-term SMA to form a buy or sell signal. The death cross and golden cross provide one such strategy, with the 50-day and 200-day moving averages in play. The bearish form comes when the 50-day SMA crosses below the 200-day SMA, providing a sell signal. Conversely, a bullish signal comes where the 50-day SMA breaks above the 200-day SMA.
Mean reversion using Bollinger bands
This strategy utilises the Bollinger band tool with the 20-day SMA placed within the middle of the bands. This technique can be used without the Bollinger bands, but using the bands provides some additional benefits. The idea behind this method is that even when we see a highly trending market, the price will often return to mean before pushing back in the direction of the trend. As such, the middle Bollinger band (the 20-day SMA) will often be utilised as support or resistance, providing a useful buying and selling tool.
The chart below highlights the strategy in action, with the price falling below the 20-day SMA on the top left, indicating the switch from bullish to bearish sentiment. From there on in, the reversion back into the 20-day SMA provided a host of profitable selling opportunities.
On this occasion, the upper Bollinger band would have been useful as a tool to place your stop loss above. Alternatively, utilising the prior swing high would have also provided a profitable trading strategy. The dotted horizontal lines signal where those swing highs are located.
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This article will discuss a specific type of moving average known as the ‘Exponential Moving Average’ (EMA). We’ll also look at an easy-to-use trading tool called the ‘Exponential Moving Average Indicator’ that uses this method to assess trends within the Forex market.
So What is An Exponential Moving Average?
An essential type of tool for assessing trends is the moving average. We use moving averages to smooth out variations in data, to better discern the underlying trend. They do this by looking back at a recent number of data points, and then calculating some form of average of the values. There is more than one way to calculate an average though, and there are several types of moving average.
The most straightforward method is the Simple Moving Average (SMA), which considers all price values equally, and takes the mean as the average. Other common types of moving average assign a weighting to different price values, favouring recent prices more heavily than older prices. This is the way in which the exponential moving average model works, with the amount of weighting assigned to a price decreasing exponentially as we go backwards in time.
What is a Exponential Moving Average?
It is fairly difficult to provide a satisfactory exponential moving average definition without getting into the specifics of the calculations involved. A broad EMA definition is: a smoothing technique arrived at by adding a portion of the current price, to a portion of the value of the previous moving average. To properly get a handle on what is going on though, we need to get our hands dirty and look at the maths. So let’s go ahead and roll up our sleeves.
How to Calculate an Exponential Moving Average
We calculate an EMA at time – t – using the exponential moving average formula as follows:
- EMAt = α x current price + (1- α) x EMAt-1
Where ‘α’ is a smoothing constant with a value between 0 and 1, EMAt-1 is the EMA for the previous period. You can see from this that calculating the EMA for a given point in time requires us to have performed prior calculations, to know the EMAs for previous periods. For a daily EMA, we derive the current value from the prior day’s EMA, which in turn we derive from the day before that, and so on.
In other words, there are some other steps involved. The first of these is to obtain a starting EMA value for the first period in our window. We also need to determine our smoothing constant. Probably the best way to illustrate the process of how to find an exponential moving average is to look at a specific example.
Exponential Moving Average Example
To keep the example simple, we are only going to use a few data values. Let’s look at how to calculate an 8-day EMA from some sample values. The table below shows the values involved in calculating the 8-day EMA.
We need a moving average value for Day 1 to begin. For this, we’ll use a simple moving average as our initial value. This is the sum of the previous ‘n’ values, divided by n. On the ninth day, we have our starting value, which is the SMA of the previous 8 day’s prices. Though the SMA is only required for the purpose of providing us with our starting value for our EMA calculations, we have included a column of SMA values.
That way, you can see the comparative values of the exponential average vs the simple moving average. We also need to use a smoothing factor. This is governed by the number of periods in the EMA. Specifically, the equation for the smoothing value is as follows:
Another way of describing what the calculation method is doing is to say that the EMA is by looking back at past values, and then discounting their weights by a factor of (1-α) per period. We can see from this that another, fuller name for the method is an ‘exponential-weighted moving average model’. Exponential moving average forecasting is a widely-used method of time series modelling in business because it works well under a large range of conditions, while also being fairly simple to calculate.
It’s common for management to make decisions based on projections of future business metrics. Such projections are often derived from EMA data models. A moving average forecasting example might include looking at previous sales data, exponentially-smoothed in order to make projections for future sales. In a similar way, professional traders use EMAs to smooth previous price data in the hopes of tapping into an ongoing trend.
In our calculations above, we only went back to include a small number of previous data points. An EMA will be more accurate the further you go back; however, and ideally, you want to be including much larger amounts of previous EMA values. Any platform worth its salt will run the exponential moving average algorithm for you, so that you don’t need to worry about the complexity of the calculations. Let’s now look at how to use the MetaTrader 4 EMA indicator.
EMA Indicator in MetaTrader 4
The Exponential Moving Average Indicator comes with the MT4 download, as one of the core tools bundled with the platform. As you can see from the image below, the Moving Average indicator is listed as one of the Trend indicators within MT4:
Source: MetaTrader 4 – How to select the EMA in MT4
The MA method field defines the type of moving average that you’ll add to the chart. In the image above, we’ve naturally selected Exponential. Apart from cosmetic choices, the two EMA settings are ‘Period’ and ‘Shift’. Of these, the more important setting to choose is the exponential moving average period. The larger the period, the smoother the chart.
The smaller the period, the more responsive the EMA line will be in responding to the price. Some typical EMA settings are 10 and 25 periods for faster, more responsive curves; 100 and 200 periods for very smooth, slow-moving curves; and 50 periods for an intermediate curve.
Obviously, just how long those trends are will be dictated by the time frame of your chart. The shift setting works by offsetting the EMA curve along the x-axis by the number you specify. The default value of 0 for the shift setting is a good place to start. The image below shows a 16-period Forex EMA indicator added to an hourly EUR/USD chart:
Depicted: MetaTrader 4 – price data from Admiral Markets – hourly EUR/USD chart – Disclaimer: Charts for financial instruments in this article are for illustrative purposes and does not constitute trading advice or a solicitation to buy or sell any financial instrument provided by Admiral Markets (CFDs, ETFs, Shares). Past performance is not necessarily an indication of future performance.
The EMA chart indicator appears as a dotted green line with the settings we have chosen. Can you see how the EMA indicator line is much smoother than the movements of the underlying price? It still traces the general movement of the market, but it effectively filters out price noise, showing us a clearer indication of the overriding trend.
It is the slope of the MT4 EMA indicator that guides us to the trend. Notice how we get a sustained uptrend after the price breaks above the EMA line? This is one of the key aspects of how to trade with the EMA Indicator – price crossing above the EMA can provide a trading signal.
Exponential Moving Average Trading Strategy
An even more effective way of reading an exponential moving average cross is by using a double exponential moving average combination, one short-term and one-long term. This exponential moving average crossover strategy creates a trading signal when the shorter EMA crosses the longer one.
For example, a long-term trend trader might use a 25-day EMA as the shorter average and a 100-day EMA as the long-term trend line. With this exponential moving average strategy, the trader would then buy when the 25-day EMA crosses above the 100-day EMA, and sell when the 25-day EMA crosses below the 100-day EMA.
Using an EMA With Other Indicators
Moving averages have more than one use. In fact, they are often paired up with other indicators in order to make trading systems. For example, a typical use can be as a trend filter for a breakout strategy. Consider a trend-following Bollinger Bands/exponential moving average breakout system – here, we would use the Bollinger Bands to provide our trading signals.
The Bollinger Bands plot a volatility envelope above and below the price on a chart. If the price breaks beyond the envelope, we would take it as a signal to trade in that direction – but only if our trend filter, which is a short-term EMA and a long-term EMA line, agreed with the direction. So for a breakout above the upper Bollinger Band, it would be a buy signal, and we would need the short-term EMA to be above the long-term EMA for us to follow the signal.
Conversely, for a breakout below the lower Bollinger Band, we would sell, but only if the short-term EMA was below the long-term EMA. There’s a lot of combinations that have been and can still be dreamt up – and the wider the selection of tools at your disposal, the greater the scope for invention. MetaTrader Supreme Edition is an plugin for MetaTrader 4 and MetaTrader 5 that offers a huge expansion in the range of indicators and trading tools at your disposal. It’s free to download, so why not try this cutting-edge upgrade?
We have seen how we can smooth price data using an exponential moving average. Not only does this indicator help confirm the trend, but it can also help to inform you when to trade, as we saw with the MT4 EMA crossover indicator strategy. As with all moving averages, you need to be aware that an EMA responds with a lag.
Because it utilises past data, the price will always be on the move before the EMA starts to move. Generally speaking, an EMA will respond quicker to newer data compared with an SMA, as it assigns more weight to more recent prices.The exact curve characteristics are governed by the period you choose, of course.
A great way to determine what the best exponential moving average settings for your own trading style are is to go ahead and test them in a demo trading account. Because demo trading is risk-free, it allows you the freedom to tinker with the settings until you can find the perfect mix for you. We hope that you enjoyed this discussion of trading with exponential moving averages.
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How to Use Moving Averages to Find the Trend
One sweet way to use moving averages is to help you determine the trend.
The simplest way is to just plot a single moving average on the chart. When price action tends to stay above the moving average, it signals that price is in a general UPTREND.
If price action tends to stay below the moving average, then it indicates that it is in a DOWNTREND.
The problem with this is that it’s too simplistic.
Let’s say that USD/JPY has been in a downtrend, but a news report comes out causing it to surge higher.
You see that the price is now above the moving average. You think to yourself:
“Hmmm… It looks like this pair is about to shift direction. Time to buy this sucker!”
So you do just that. You buy a billion units cause you’re confident that USD/JPY is going to go up.
Bammm! You get faked out!
As it turns out, traders just reacted to the news but the trend continued and price kept heading lower!
This gives them a clearer signal of whether the pair is trending up or down depending on the order of the moving averages. Let us explain.
In an uptrend, the “faster” moving average should be above the “slower” moving average and for a downtrend, vice versa. For example, let’s say we have two MAs: the 10-period MA and the 20-period MA. On your chart, it would look like this:
Above is a daily chart of USD/JPY. Throughout the uptrend, the 10 SMA is above the 20 SMA.
As you can see, you can use moving averages to help show whether a pair is trending up or down. Combining this with your knowledge on trend lines, this can help you decide whether to go long or short a currency.
You can also try putting more than two moving averages on your chart. Just as long as lines are in order (fastest to slowest in an uptrend, slowest to fastest in a downtrend), then you can tell whether the pair is in an uptrend or in a downtrend.
Beginners Guide to Trading Moving Averages for the Crypto Market
Using candlestick formations in order to determine price movement from one direction or another is great for what it does within a more confined timeframe. The problem is, the level of detail that you get from candlestick formations is so granular, that it may be hard to determine the overall trend across the daily highs and lows of a particular cryptocurrency.
This is where moving averages come into play and why they’re one of my all-time favorite trading signals for both ease-of-use and reliability.
Moving averages will really help you break down the momentum of a particular crypto coin. These averages are represented by a simple line which gives an indication as to where a coins price was and is most likely going to be, in an easy-to-see format.
Let’s start off with one of the most basic moving averages…
Simple Moving Average
This moving average, as the name implies, is a simple line that represents the closing price of a cryptocurrency, which is averaged out over a period of time.
In layman’s terms, you simply write down the closing prices for say the last 30 days, add them all up, and then divide that total by 30. This will give you the average of that particular number set.
The most common simple moving averages that you’ll read about are the 50, 100, and 200 day moving averages. Each of these three moving averages will show the momentum during their respective time period (50 days, 100 days, or 200 days).
The only weakness behind simple moving averages is its inherent simplicity, where the data points are assigned the same weight, which affects the outcome of each one equally. This means if you have a price that is severely out of range, compared to the other price points, this can skew the simple moving average line, which in turn can give you inaccurate results.
Let’s look at an example for context…
Say the first four days of price action was at $3, $4, $4, $5, and then a whopping $25. The simple moving average line would then be centered on the average of $8. As you can clearly see, this major movement in price tends to greatly disrupt the averages.
Don’t worry; I cover a strategy further down this guide utilizing the exponential moving averages alongside simple moving averages, that will help facilitate the correction of this issue.
For now, let’s discuss the 3 most common types of simple moving averages.
50 Day Moving Average
A 50 day moving average measures the short-term market confidence. This moving average is consistently used by swing traders, due to its accurate representation of the market during a 24 hour period.
When price action is above the 50 day moving average, this indicates that you’re in a short-term bull market. The opposite rings true for price action below the 50 day moving average. This would clearly indicate that you’re in a short-term bear market.
Also worth noting, when candlestick formations are moving between bullish and bearish sides of the 50 day moving average, this indicates a “ranging period” where the market is undecided where it wants to go. Trading during these ranging periods is much riskier than trading in a substantiated trend (bear or bull trend).
As you can imagine, trading alongside a trend is much more predictable than trading sideways where the market sentiment has yet to be determined.
What’s interesting about the 50 day moving average is that it’s sensitive enough to show large institutional buys or selloffs. These price movements are recorded more accurately on this shorter-term moving average.
100 Day Moving Average
This moving average is considered a medium-term momentum indicator. These are characterized by sharp changes or reversals in the market and tend to include large economic or political movements. You can expect the 100 day moving average to move opposite of the primary trend that follows the 50 day. Much like the 50 day moving average, prices above the 100 day moving average are more long term bullish and prices below this line are bearish.
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200 Day Moving Average
As you might expect, the 200 day moving average is a crucial gauge for longer-term trends. This is what you would call the “big picture” or “birdseye view” on how a particular market is doing.
This moving average is not going to tell you where to place a buy or sell order on a day or swing trading basis, however it will let you know whether you need a hold on to a cryptocurrency for a while or if you should start thinking about exiting the market.
I typically use the 50/200 SMAs cross to get an overall feel for where the market is currently and the direction it will be headed when swing trading. I cover more on this strategy below under “The CCJ Moving Average Strategy”.
The Golden Cross
The Golden Cross is defined when the line of a short-term moving average crosses a longer-term line. This cross indicates that a bullish or bearish breakout is imminent. You can look at the cross as a warning of what’s to come (think red alert).
So for example, if you have a 50 day moving average cross over a 200 day moving average, this indicates that bearish sentiment is soon approaching. The same goes for bullish sentiment. If the 50 day moving average crosses under a 200 day moving average, this indicates that bullish sentiment will soon take over.
The reason I use the 200 MA as opposed to the 100 is due to the fact that there is a much larger separation between these 2 moving averages. The 50 and 100 MAs tend to overlap one another.
It’s important to note that bearish or bullish sentiment is soon approaching once these two lines move closer together. You don’t always have to wait for a cross, but it is preferred for confirmation.
Next let’s talk about one of the most utilized moving averages for both day and swing traders alike.
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