Have you heard of the concept of moving average, something that is often abbreviated MA? Moving averages are an extra interesting indicator for anyone who invests in equities.
It helps you to detect trends and you can use it if you are engaged in trading.
With a moving average, you can get an insight into both long-term and short-term trends and you can calculate the average for any time period you want.
So, what is a moving average?
Moving averages are a tool used in technical analysis to identify trends, support and resistance as well as generate buy and sell signals. The moving average is calculated by calculating the average price over X number of previous time periods.
Moving averages are usually called MA. There are different types of moving averages, but in this article we will only stick to the classic simple moving average.
It is also what most people use so you do not have to bother with it for yourself.
In-depth explanation of moving average
A moving average is a technical indicator used to reduce the price change.
This is done by calculating an average of the price, usually the closing price, with the length of the review period.
The average value is then drawn on the chart, which gives traders and investors the opportunity to visually determine the direction and strength of the trend.
The length of the moving average depends on what it is used for.
A longer look back works well for measuring long-term trends, while shorter lengths are better for detecting momentum and short-term directions in the market.
The most common and most commonly used setting for a moving average is 5, 10, 20, 50, 100 and 200 graphs of moving averages.
Of these, the 200-day moving average is the most widely used indicator.
Investors and traders often use it to assess whether the market is bearish or bullish and to time the longer fluctuations in the stock markets.
This is how you use moving averages when investing
Moving average is a way to use technical analysis to identify buying opportunities in shares you are interested in.
The concept of technical analysis may sound a little daunting, but it does not have to be that complicated.
Mixing technical and fundamental analysis, with patience and interest is often a great way to be successful in the long run.
The moving average above all can help you identify is trend break: when the stock price gradually begins to fall, or when the price of the stock is in a rising trend.
When the price breaks the average
The easiest way to use the moving average is to look at the trend over the medium (MA50) or long time (MA200). When the price crosses the average from above, it means that the price is probably on the way down.
If, on the other hand, the price crosses the trend from below, the probability indicates that the price will continue to rise.
When two averages break each other
In order to identify trend breaks in a share price with greater statistical certainty, two different averages can be combined.
What you are mainly looking for is to identify what in technical analysis terms is called “Golden cross” and “Death cross”.
The golden cross indicates when buying opportunities arise. The cross of death shows when it’s time to pull out.
These opportunities arise in the same way as described above, but instead of the average value being set in relation to the actual share price, the values are set in relation to each other.
When the shorter average value breaks the long one from above, a “Death cross” occurs and it is time to sell.
However, when it breaks from below, a “Golden cross” arises
Calculate moving average
A moving average consists of the average of several different numbers in the data used.
What you use to calculate a moving average is a specific mathematical formula. You choose the time period you want to use as a basis for your calculation.
You use a given set of values to create a series of means. You then compare the mean with your moving average.
What you want to get is the point where an average value with a narrow window intersects a window with a wider time interval.
Then you get a buy or sell signal in trading.
You calculate the moving average by taking a share price over a specific time period and dividing the sum by the total number of periods.
This calculation is called SMA, but so is EMA.
If you use a well-known platform for your trading, you often do not need to calculate the moving average on your own. Instead, the platform handles this for you so that the information is always available.
SMA vs. EMA
SMA stands for simple moving average while EMA stands for exponentially moving average. These two are different types of moving averages and help filter out short-term volatility from the stock market.
Simple Moving Average (SMA) shows the average price over any time period.
The exponential moving average (EMA), on the other hand, is more responsive to current price movements. This is because more emphasis is placed on recent data points when calculating EMA.
Both of these moving averages are good to use and there is nothing that trumps the other.
Instead, they can be used in different ways and for different types of strategies.
As a trader, you should therefore familiarize yourself with both SMA and EMA and choose the average value depending on which lens you have ..
In general, it can be said that the exponentially moving average shows less delay and turns faster. One risk with this is that it can give unreliable signals.
If you instead use a simple moving average, you get a clear overview of the actual average price for the period you have chosen to have as a basis for the calculation.
SMA can be really good to use to identify support and resistance levels.
How do you use moving average for your trade?
You can use the tool mainly to identify trends, find support and resistance and get buy and sell signals.
1. Identify trends
If the average value you look at points upwards, it is usually said that the trend is upwards in the time horizon you are looking at.
It is not more difficult than that. If you have a graph that is set to the time period days and you have entered an MA200 line and an MA50 line in the graph, it may be that the 200-day points upwards while the 50-day points downwards.
Then you have a situation where the long-term trend is positive while the more short-term trend points downwards.
This may mean that the long-term trend is about to reverse or that the stock, the index or whatever it is you are looking at only makes a minor rebound in an upward trend.
You also usually look at whether the price is above or below the moving average.
2. Find support and resistance
If you look at the averages that the rest of the market uses most often, you can use averages as support and resistance.
The older the mean, the greater the probability that the resistance or support holds for a test.
MA200 is significantly stronger and affects more than MA20.
If you look at the MA200 in the daily graph, it is probably the most used average. This means that there are always reactions in the course when the price reaches MA200 days.
This means that there are always a lot of buyers and sellers in the market around the line and there is a lot of foul play from the major players around these lines.
3. Buy and sell signals
Many people use averages such as buy and sell signals.
An example is that you buy if the price exceeds the moving average and sell if the price falls below the average. Example:
The price rises above MA200 = buy signal
The price goes down below MA200 = Sales signal
Another way is to look at two different moving averages at the same time, for example MA200 and MA50 in the daily graph. When these cross each other, a buy or sell signal occurs. Example:
MA50 crosses MA200 from below = buy signal
MA50 crosses MA200 from above = sell signal
Precisely MA200 and MA50 in the daily graph are the most used because when they are crossed, buy and sell signals occur which are called the golden cross and dead cross.
The whole idea behind it is that the short-term trend, MA50 breaks below the long-term trend MA200.
This gives the signal that the long-term trend is about to decline and therefore a sell signal arises.
You can play with these averages indefinitely to create different strategies. Most people usually end up falling back to using the most commonly used averages and then using it as part of a larger strategy.
If you only trade with the help of moving averages, ie the entire strategy is based on these, it tends to work best in larger time periods such as a monthly graph.
Strategy for trading with the help of MA in the monthly graph
I have an example of a strategy based on moving averages. I set the graph by month and I then use MA12.
I buy when a price bar (monthly bar) closes above MA12 and we sell when a price bar closes below MA12.
If you manage to find a stock, an index or a commodity that is trending very much, this simple strategy can be ingenious.
It can provide extreme excess returns compared to a “buy and hold” strategy. However, it works worse when the supply you buy does not trend so strongly.
Moving averages are an important tool in technical analysis and come in many forms and give traders a visual tool to determine the direction of the trend, as well as momentum.
The different types of moving averages can be categorized into two groups; weighted and simple moving averages.
The main difference is the differences that weighted averages do not place equal weight on all data points, while simple averages do.
Along with another moving average, or just with price, there are many different entries that traders and investors can use.
Golden crosses, death crosses and crossovers are some of them. There are also many indicators that have evolved from moving averages.
Bollinger bands and the MACD are two examples of such indicators.