Over the lifetime of an asset, price valuations can vary significantly. In most cases, traders use tools to help consolidate and simplify those changes using moving averages. This is a very simple concept. Price is simply averaged over a certain period of time and shown as a chart line appearing next to the price. If we are looking at a Daily chart and using a 10-period moving average, the line that appears will show the price average from the 10 previous days. If we used an hourly chart, the average would show the price of the 10 previous hours. If it is a 5 minute chart, we would see the average of the 10 previous 5-minute periods. Here is what a 100-period SMA looks like on a chart:
The most common time frames that are used when traders add moving averages to their charts are the 200-day, 100-day, 50-day, 20-day and 10-day. Typically, the 200-day average is considered to be equal a trading year, while the 100-day average constitutes a half-year, and 50-day average as representative of a quarter of a year.
The simplification of price activity that can be achieved when using these tools can help us gain a better understanding of the typical value of the asset over the time period. This can become especially useful when we see high volatility and large price swings. Many traders would argue that when we see significant diversions from the mean, buying and selling opportunities become readily apparent. Additionally, we can gain a better understanding of the overall trend when we compare the current price to the longer term averages.
In trading, however, all moving averages are not created equally. The averages described above are the ones most commonly used and are classified as “simple” moving averages, or SMAs. These are calculated differently from exponential moving averages, or EMAs, which weigh recent data more heavily. Longer-term averages are seen by traders as being more credible and important than those created by short-term fluctuations, and it is usually assumed that higher probability trades are based on these longer-term averages.
Furthermore, the exponential moving average is thought by many to be a more realistic measurement, due to the dynamic nature of the modern trading environment. Fundamental news stories can change the market atmosphere dramatically and some argue that the EMA is a more efficient way of accounting for this phenomenon. An understanding of the calculations required to generate the EMA are largely unnecessary because, now, trading platforms do the calculations for you. What is important to note is the difference between the EMA and the SMA in the way the data is weighted. Here is a 100-period EMA on the same price activity, the numbers change and this makes a difference when defining specific parameters for trade exits and entries:
Moving averages are useful for a multitude of reasons. In addition to providing a consolidation of historical price activity, they provide a simple method for determining whether prices are trending up or down. This determination is made in two ways: First, upward sloping averages are showing uptrends, while the reverse is true for downtrends. The example above appears to be showing us a burgeoning uptrend.
Pay special attention to the ways the price has behaved around the moving average. The first break above the average struggled, clung to it, and dipped. The main idea when a moving average is violated is that prices which have broken above the moving average (or below it, in reverse cases) present us with a trade signal. This activity leads a technical trader to believe that the trend is most likely to continue in the direction of that break, either up or down. This example first shows what would be classified as a “false break” because the buying struggled and then failed to continue. The second break above the average presented a successful buying opportunity, as prices quickly shot higher once the moving average was overcome. Had a trader bought the asset after seeing the break, positive gains would have been realized.
Another example of a trade signal can be seen when traders pair averages and look at the ways they interact with each other. Most traders who put moving averages on their charts use two or three in tandem. A shorter-term moving average crossing above a longer-term average gives us a trade signal, as prices are expected to continue in the direction of that cross.. This is a more typical example, and shows us a buy signal:
Notice how the signal predicted a sharp upward movement. Would it have been easy to anticipate that move without looking at the averages? This would be unlikely. We have been looking at the same price action (same chart) during this entire lesson but only the signals provided by the moving averages have enabled us to see the possibility of a trade entry.
Another common way moving averages are used is to identify support and resistance levels. It is not uncommon to see a stock that has been falling stop its decline and reverse direction once it hits the support of a major moving average. A move through a major moving average is often used as a signal by technical traders that the trend is reversing. For example, if the price breaks through the 200-day moving average in a downward direction, it is a signal that an uptrend could be changing its course.