Among hundreds of different indicators and technical tools for traders, the relative strength index (RSI) is one of the most popular due to its simplicity and, at the same time, its power in various trading cases. In this article, we want to tell you about another powerful tool similar to RSI but with some cool tweaks.
8 Facts About Moving Averages
2022-03-25 • Updated
Information is not investment advice
Moving averages (MAs) are key instruments that even amateur traders use widely when they want some help with analyzing a price chart. In this article, we’ll go through the basics of moving averages and then learn some life hacks that will help you to use this tool for boosting your trading results.
What’s a moving average?
Moving average is a trend indicator. It takes price averages and, as a result, smooths out price action from fluctuations. For example, a 20-period moving average shows the average price for the past 20 periods. Have a look at such a line added to the chart in the FBS Trader App.
With a help of moving averages, you can make smart trading decisions. For example, when the price trend isn’t clear, the MA will show it to you. If the MA goes up, it’s an uptrend. If the indicator goes down, it’s a downtrend. Moreover, you can use MAs as support and resistance lines. If the price approaches a moving average from above, there’s a chance that the line makes it stop on the way down or even turn up. If the price rises to a moving average from below, there is a chance that the line makes it stop on its way up or even reverse down. Just add a MA to the chart in MetaTrader 4 or 5 or in FBS Trader and you will automatically get the support and resistance levels.
The main types of MA are:
- Simple MA shows the average value of the closing prices for the period under review. As a result, all prices are equal in value. For example, if we have a 20-day moving average, we add up all 20 closing prices and divide it by 20. Each time a new closing price forms, the oldest one is removed from the calculation.
- Exponential MA and linear weighted MA are very similar. They calculate the latest prices with a higher coefficient. As a result, these MAs react to the price changes and give signals faster. Be careful! Although these moving averages give fast signals, some of them may be false.
- Smoothed MA is based on a simple moving average, but it clears price movements of fluctuations so that it becomes easier to determine the trend.
Facts about moving averages
Now that we are familiar with the idea of the indicator, let’s look through 8 facts about moving averages that will make your trading more productive and your analysis more proficient.
1. Use different periods of moving averages
The 21-day moving average usually marks the short-term trend, the 50-day moving average marks the intermediate trend, and the 200-day moving average marks the long-term market trend.
2. Moving average is only a technical indicator
Moving averages only draw trends based on the past price information. Like any technical analysis tool, charting indicators don’t take into account changes in fundamental factors that may affect the future performance of a financial asset. For currencies, such factors include economic growth, inflation, labor market figures, and central bank policy. For stocks, fundamental factors are higher or lower demand for the industry’s products, new rivals on the market, or changes in a company's management structure.
3. EMA or SMA?
There’s an ongoing debate about whether traders should pay more attention to the very last days of a period (for example, using EMAs). Many people feel that the latest data is a better indication of the price’s direction, while others feel that giving some days more weight than others misrepresents the trend.
Exponential moving averages give more weight to the recent price changes, while simple moving averages treat every data point in a timeframe equally. SMAs are great as dynamic support and resistance lines, but many trading strategies use EMAs. Thus, in general, if we compare SMA and EMA with the same period on a chart, the difference won’t be that big.
4. Moving averages and momentum
When the price has more momentum (speed), it can travel a bigger distance from a MA before this moving average pulls it back. The gravity of the moving averages brings the price back to the mean. The angle of the two faster moving averages and the difference between them will indicate if the price has enough speed to break away from its average. The best moving averages for determining momentum are from 5 to 40 EMA. For example, a trader may choose 5 and 10 EMAs, or 10 and 20 EMAs, or 20 and 40 EMAs at the close.
A gap between the two EMAs will indicate momentum and, therefore, the price speed. When this gap widens significantly, it means that the price may soon lose momentum, reverse and return to the averages.
5. Moving average to estimate a long-term trend
The position of the price on a chart relative to the 200-period moving average indicates whether there’s a bull or a bear market. This line generates one of the most important market signals. In general, bulls remain confident when the price stays above the 200-period moving average. It means that when such situation occurs, buying on pullbacks to the downside is preferable. Bears, on the contrary, prefer opening sell trades on rallies when the price is below the 200-period MA. Many important trend-following trading systems are built using this indicator as the main one.
6. MA as a signal
Some traders look for situations when a moving average starts sloping up or down and see this as a signal of a start/change in trend. In addition, it may be easier to notice trend changes and get signals by having two moving averages with different periods on one chart. Let’s consider a 50-period MA and a 100-period MA. A bullish signal occurs when the 50-period MA (a line with a smaller period) rises above the 100-period line. The signal is called the “golden cross”. Alternatively, traders see a bearish signal when the 50-period MA gets below the 100-period line. This would be a “dead cross”.
Notice that the signals of the crosses are more reliable if the MAs move apart after the crossing and the price has momentum.
7. Divergence issues
Moving averages are ideal targets when there’s a divergence. On average, when divergence between the price chart and some oscillator occurs, a trader can expect the price to return at least to the middle ground between the 100 and the 150 EMAs. It’s possible that the price sometimes doesn’t return within the moving average band. However, if the price reaches or approaches these MAs, the trader can consider that the trade on the divergence is over.
8. Flat or angled?
If moving averages are flat, they have a very strong gravitational pull. The price will have many problems trying to move away from the average. On the other hand, if moving averages are angled, then they have very little gravitational pull. The price will have time to move away from the average faster.
Once again, remember that moving averages turn into dynamic support and resistance levels. When the price returns to them, it can use these levels as a rough area to continue the trend (bounce up from support in an uptrend and turn down from resistance in a downtrend).
Remembering these tips, you can make your trading experience brighter. Try to pay attention to the details and don’t forget: practice makes perfect. So, use the moving averages in your daily trading and your technical analysis will bear fruit!
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