What Are These Moving Averages?Moving averages rely on past data, they are considered to be lagging or trend following indicators. Regardless, they still have great power to cut through the noise and help determine where a market may be heading.
Different types of moving averages
There are various different types of moving averages that can be used by traders. Despite the various types, the MAs are most commonly broken down into two separate categories: simple moving averages (SMA) and exponential moving averages (EMA). Depending on the market and desired outcome, traders can choose which indicator will most likely benefit their setup.
The simple moving average
The SMA takes data from a set period of time and produces the average price of that security for the data set. The difference between an SMA and a basic average of the past prices is that with SMA, as soon as a new data set is entered, the oldest data set is ignored. So if the simple moving average calculates the mean based on 10 days worth of data, the entire data set is constantly being updated to only include the last 10 days.
It's important to note that all data inputs in an SMA are weighted equally, regardless of how recently they were inputted. Traders who believe that there's more relevance to the newest data available often state that the equal weighting of the SMA is detrimental to the technical analysis. The exponential moving average (EMA) was created to address this problem.
The exponential moving average
EMAs are similar to SMAs in that they provide technical analysis based on past price changes. Nevertheless, the equation is a bit more complicated because an EMA assigns more weight and value to the most recent price inputs. Although both averages have value and are widely used, the EMA is more responsive to sudden price fluctuations and reversals.
Cause EMAs are more likely to project price reversals faster than SMAs, they are often especially preferred by traders who are interested in short-term trading. It is important for a trader or investor to choose the type of moving average according to his personal strategies and goals, adjusting the settings accordingly.
MAs of 50, 100, and 200 days are the most commonly used.
How to trade with MA?
Generally, a rising MA suggests an upward trend(acts as a support when rising under a price) and a falling MA indicates a downtrend(acts as resistance when falling above a price). Though, a moving average alone is not a really reliable and strong indicator. Therefore, MAs are constantly used in combination to spot bullish and bearish crossover signals.
A crossover signal is created when two different MAs crossover in a chart. A bullish crossover (also known as a golden cross) happens when the short-term MA crosses above a long-term one, suggesting the start of an upward trend. In contrast, a bearish crossover (or death cross) happens when a short-term MA crosses below a long-term moving average, which indicates the beginning of a downtrend.
One major downside of MAs is their delay time. Since MAs are lagging indicators that consider previous price action, the signals are often too late. For example, a bullish crossover may suggest a buy, but it may only happen after a significant rise in price.
This suggests that even if the uptrend continues, potential profit may have been lost in that period between the rise in price and the crossover signal. Or even worse, a false golden cross signal may lead a trader to buy the local top just before a price drop. These fake buy signals are usually referred to as a bull trap.
To put it all in a nutshell, Moving Averages are powerful TA indicators and one of the most widely used. The ability to analyze market trends in a data-driven way provides great penetration into how a market is performing. Remember that MAs and crossover signals should not be used alone and it is always more reliable to combine different TA indicators in order to avoid fake signals.
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