i. Moving averages give the average of the price over a time period.
ii. Simple Moving Average and Exponential Moving Average are the most commonly used moving averages.
iii. EMA is faster in reacting to price movement and it gives more weightage to the latest price.
iv. Smaller length moving average for smaller timeframes and longer length moving average for longer timeframes.
What are moving averages?
Let’s consider that you found a rare painting while you were cleaning your house and you decide to list it on some online marketplace in order to find out its value and maybe you could sell it.
You get five offers for your painting and each one of them is for a different price. Now, if you are to determine a specific value for your painting, how would you do so? By taking an average.
Add all the offers and divide it by the number of offers and you get an amount that is the average of all the offers you received and this is what your painting could be worth.
Does this concept of averages ring any bell in your head? I am sure you must have learned this in school.
Who knew that one of the most basic things that we learned in math class would be something that is used in trading.
So, moving averages, as the name suggests, is basically an average. It is an average of price over the past.
Moving averages are a technical indicator that traders use that constantly calculates price averages and smoothens them out to provide traders a line with a slope.
The ‘moving’ in moving averages means that it is constantly updated. This means that older data is replaced with newer data and this allows the moving average to be a continuously flowing sloping line.
For instance, we have the closing prices of a particular currency pair for 5 days and it is 1.0, 1.1, 1.2, 1.3, and 1.1.
The moving average indicator would add up these values which amount to 5.7 and then this will be divided by 5 i.e. the number of values. We will then get an average closing price of 5 days which is 1.14.
Now, we get the closing price of the 6th day, then here, the moving average will discard the price data of the first day and will include the latest price data in the set and a new average will be produced.
Each average can be seen as a point on the chart and since it is a moving average, it keeps recording these average points. When we join all these points and smoothen them, we get a moving average.
If the moving average is sloping upwards or if it seems to be moving upwards then it means that the market participants have a bullish bias.
A downward sloping moving average means that the bias of the market participants has been bearish.
Types of moving averages
There are several types of moving averages that have been created but I am going to limit the scope here to just two of the most widely used moving averages.
1. Simple moving average (SMA)
This is the most basic type of moving average and its calculation is the basic calculation of averages.
In a simple moving average, all price data is added up and it is divided by the number of price data and the output is the price average for that particular time period.
2. Exponential moving average (EMA)
The EMA is more of an advanced type of moving average. It is faster than other moving averages and its calculation is not as simple as calculating averages.
In this type of moving average, the most recent price data is given higher weightage and this is one of its biggest advantages.
Why you should stop using SMA and start using EMA
There are two problems or disadvantages that are associated with SMAs and you might feel that these are menial issues but at times in trading, it makes a big difference.
The most obvious issue with SMAs is that it does not give any additional weightage to the most recent price data.
For instance, if the last five day’s closing price is 1.2, 1.25, 1.3, 1.4, and 1.35, the average is 1.3.
If on the next day, the price closed at 2.0, the SMA will treat it as just one of the five numbers in the set.
The issue with this is that the SMAs are very slow in reacting to the price movements. You will often see that the price has already shot up or down but the SMA has still not absorbed this.
There was one instance where I was just observing charts of some currency pair or maybe some commodity and I saw that the price tanked. It was a really big fat red candlestick that just dropped.
I had an SMA applied on the chart and I saw that even though the price moved so aggressively, the SMA did not move much.
This is the second problem that SMA users will face, that at times due to its slow reacting nature price whipsaws will keep giving poor signals.
Now, coming to the EMAs, we will not get into the calculations part of it but let me tell you one thing that in a 10 EMA, the recent price data is given 18% weightage compared to a 10% weightage that the SMA would give.
This makes EMAs faster to react to newer price points and the EMA follows up with the prices very quickly.
In the case of price whipsaws, EMAs will move along the price and the signals that it outputs will be better than what you will get in SMAs.
See, as a trader you need to see what price has done in the very past but you also need to see what price has done very recently and this recent price movement has more significance as it shows what exactly is happening at that very moment.
EMAs solve this for you and you have a price average that reacts quicker to price movements and it is a tool that you should start using over the basic and outdated SMAs.
The psychology behind moving averages
The biggest reason why traders use moving averages in trading is to find out what is the sentiment or mood of the market participants.
You cannot just wake up one day and decide to go short in a currency pair while the market bias is bullish, you will just lose money.
Like I mentioned earlier, an upward sloping moving average indicates a bullish bias while a downward sloping moving average indicates a bearish bias.
What if one day I show you a picture of a man and I ask you whether the man is an optimist or a pessimist, will you be able to answer just by looking at one single picture? No, I don’t think so.
But, if I show you multiple pictures of the same man then I am sure you will be able to tell whether he is a person with positivity or negativity.
Now, applying this same logic to price movements, if I tell you the closing price of a currency pair on any random day, will you be able to tell if it was a bullish or bearish day, and will you be able to comment on its trend? No.
If you have price data of multiple days and if you take an average of all the data then you will get a price trend and then you can decide if the price is bullish or bearish currently.
It is a normal convention among traders that if the price is above the moving average then it is bullish as it is trading above the average over the past trading sessions.
And if it is below the moving average then it is a bearish signal.
Using the slope as well as the position of price with respect to the moving average, traders can get a better understanding of how price has behaved in the past and how it can behave at the moment and maybe in the future too.
What’s the right length for moving averages?
When I was a beginner and when I was trying to learn this skill of trading, I came across many articles, videos, and traders saying that we choose any random length for moving averages and trade them.
But now, as I have gained experience, I have understood that whatever beginners were taught did not make sense. You cannot just come up with any random moving average and expect things to work.
One method that you can use while setting the length for the moving averages is to find out for how long a particular trend cycle has been going on and then divide it by two and use this as the length for the moving average.
For instance, open any currency pair chart and count the number of days the price has been in a trend, either direction.
Let’s consider that the pair has been in an uptrend for around 200 days, then here, you will use a moving average with its length set as 100.
Another method to determine moving average length is to first figure out what kind of trend are you looking to capture, a long one or a short one.
Once you figure this out, you can use a longer period moving average for a longer trend and a shorter length moving average for a shorter trend.
Any moving average that you use should never be less than 8 timeperiod as anything below this will give you a large number of whipsaws and false signals.
You can also set moving average length according to the time frame you are trading.
For larger time frames you will be better off using moving averages of longer length and for shorter time frames you should use moving averages of shorter length.
One very important thing about moving average length is that you have to make sure that it is not too long and not too short. You need to find a sweet spot that fits in just right according to what you are trying to achieve.
If you use a longer length moving average then you will be left behind lagging as the price keeps moving while a shorter length moving average will become over-sensitive to the price and will lead to excessive whipsaws.
Moving average trading strategies
Moving average is a trend riding tool. It tells us about the trend and particularly in which direction the trend is moving.
A moving average with an upward sloping line is indicating a bullish trend while a downward sloping moving average is a bearish trend indicator.
You should only take long trades when the moving average is bullish and only short trades when it is bearish.
Moving averages should be used to trade trends only and nothing else.
Read ahead to learn some methods that you can use to trade moving averages.
1. Moving averages pullback setup
Let’s consider that the price is already trending upwards and is quite far from the moving average, you cannot just randomly take a trade here.
You should wait for the price to fall back towards the moving average or it should pull back towards the moving average.
You will then take an entry in the prevailing trend. If the price was in an uptrend and pulls back to the moving average, you will only take long trades.
If it was in a downtrend and then it pullback to the moving average, then you will only take short trades.
In such setups, the stop loss will be below the recent swing low in the case of long trades and will be just above the recent swing high in the case of short trades.
Targets will be flexible and you should trail stop loss as and when price moves in your favor as moving average is a trend riding indicator and you should use them to catch large trends.
2. Moving average reversal setups
If you apply a moving average on a price chart and observe it, you will see that at times price, even though in a trend, just breaches the moving average and keeps moving in the opposite trend and has a trend reversal.
These setups are often difficult to trade because once it takes place, it takes place very fast and you might miss the opportunity.
The setup here would be that, if the price, already in a downtrend, moves up and breaks the moving average to the upside, then you have to shift your bias from bearish to bullish.
Entry will be taken just above the candlestick that closed above the moving average and stop loss will be placed just below the recent swing low.
In case the reversal candlestick is too long, then you will wait for the price to retrace a little to the moving average, and then you will take entry.
Targets again will be flexible and stop loss should be trailed to capture and capitalize on the big price swings.
3. Moving average crossovers
In moving average crossovers, you will be using 2 or even 3 moving averages at one time.
In such setups, one moving average will be a slower one or with a longer length and the other will be a faster one will a shorter length.
Moving average crossovers are of two types, bullish and bearish.
If the faster-moving average crosses the slower moving average to the upside then it is bullish, if it crosses it to the downside then it is bearish.
Here you might have a question as to how to decide length for the faster-moving average, the thumb rule that I follow is to go half of the slower moving average.
For instance, if you use a 50-period moving average, then your fast-moving average will be 25.
In moving average crossover setups, you are not supposed to take trades but rather you are to see it is a market indication.
Whenever you see a bullish moving average crossover, you should understand that the trend is going to change and you should become prepared for long trades.
In bearish crossovers, you should expect the bullish trend to become bearish now and you should plan for short trades.
4. Ranging market
There will be times when the moving averages are just moving in a series of crests and it seems like they are moving aimlessly.
This happens in ranging market conditions where the price is stuck within a range and is unable to break out of it and the moving averages just keeps following in inside this range.
In such cases, you have to stop treating moving averages as a trend riding indicator, and here you will have to listen to what it is telling you.
In ranging markets, the moving averages will make it very evident to you that the price is stuck within a range and you should apply those setups which allow you to capitalize on such price movements.
These setups will mostly be trades taken at the upper or lower end of the range and you can use chart patterns, candlestick patterns, or even divergences to trade.
Do you use moving averages?
Do you incorporate the moving average indicator in your trading and if you do then what is your strategy or setup like? Do let me know.
Share this blog post with every trader you know and let them also take advantage of these untold moving average secrets.
You can always ask any questions or doubts you may have in the comments section and I will get back to it for sure.