Moving averages (MA) are one of the oldest and the most popular technical analysis tools. There are different types of moving averages, including simple, exponential, time series, triangular, variable, volume-adjusted, and weighted. You can also calculate a moving average of another moving average. The simple moving average is the most commonly used method. Keep in mind that moving averages are most useful in trending markets, and don’t work as well in sideways or choppy market conditions.
What is A Moving Average?
A simple moving average (sometimes called arithmetic), is used to calculate the average price of a commodity at a specific point in time. It can be used as a basis to determine support and resistance points than can be useful for developing appropriate entry and exit points on trades. If the market’s price is above a specified MA, that’s a bullish signal, and when it’s trending below, it’s bearish.
Calculating a Simple Moving Average
Calculating the simple moving average is just that—simple. A five-day moving average would result from taking data points from the prior five trading days, adding them together, and then dividing by five. Which data points you use is up to you. Many traders will use the closing prices in calculating moving averages, but you can also incorporate the high, low and close into your calculations. Find what gives you a unique edge.
Moving averages are useful in suggesting a trend in either direction, and can be used in any time frame. As a general rule of thumb, shorter-term traders would use a MA based on shorter time frames. Very active day-traders who are in and out of the market quickly might even use five-minute, 10-minute or 30-minute time periods.
In general, the shorter the moving average time frame the more sensitive it is likely to be. If you are a long-term trader, you could get false signals if you rely on these. Some traders like to combine a short-term moving average with a long-term moving average. When a short-term moving average crosses over a long-term moving average (called a crossover), it is thought to provide a contrarian short-term signal.
Below are guidelines on which time frames to use.
- Short-traders might focus on 5- to 25-day moving averages
- Intermediate-term traders might use 26- to 59-day moving averages
- Position traders might use 50- to 100-day moving averages
- Long-term position traders might use 100- to 200-day moving averages.
Also, watch your technical momentum indicators for confirmation. When you see the Stochastic and/or Relative Strength Index turn bullish or bearish, you might want to tighten up your moving average time frame. As mentioned, the short-term the moving average, the more sensitive it will be.
This article just scratches the surface in terms of moving averages. One of the potential drawbacks of using a simple moving average is that it is a lagging indicator. That is, you are viewing what happened in the past. Exponential moving averages help alleviate this problem, by applying more weight to more recent data. Moving averages should not be relied on exclusively in making trading decisions, but they can be a very useful tool to confirm other technical or fundamental indicators. We encourage you to explore this topic further, and contact us if you have any questions.