Moving With Changing Averages

“Markets are constantly in a state of uncertainty and flux and money is made by discounting the obvious and betting on the unexpected.”

– George Soros

Moving averages represent an ideal analysis tool for the beginner trader to take his or her initial steps in financial markets. Moving averages are easy to calculate and comprehend. While they are viewed as very simplistic, when applied correctly, moving averages could help while trading.

What are Moving Averages?

A moving average is the average price of an asset over a given period of time. Typical moving average time periods include 20, 50, and 200 days. However, depending on a trader’s time horizon and trading strategy, moving averages can also be successfully applied to shorter time frames.

What are the Different Types of Moving Averages?

Moving averages can be grouped into two main categories: simple moving average (SMA) and exponential moving average (EMA).

1. Simple Moving Average

A simple moving average is nothing but the average price of an asset during a specific period of time. Simple moving averages can be based on any closing price quotes, be they 5 minutes, hourly, daily, weekly, or monthly.

A 3-day simple moving average is the sum of the daily closing prices over the preceding 3 days divided by 3. As the name itself implies, the average keeps moving, whereupon old price points are dropped from the calculation to incorporate new data when they become available.

2. Exponential Moving Average

The exponential moving average looks very similar to a simple moving average. However, if you dig a little deeper, you will observe subtle differences in the way they are plotted. EMAs were introduced to decrease the time lag that is characteristic of simple moving averages.

This is achieved by attaching greater emphasis to recent prices, instead of treating each price point as equal, which is precisely what the simple moving average accomplishes.

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What Can Moving Averages Tell Us?

Moving averages are primarily utilized by traders to identify the direction and strength of a trend. This is achieved by simply viewing the slope of a moving average curve. A steadily rising moving average suggests that an asset is in an upward trend. A moving average that has a persistently declining slope signals prices are in a downward trend. A flat moving average curve is indicative of a directionless (trendless) market.

With a Standard Account from FXTM, traders can add both the simple and the exponential moving averages to the charts available on the MT4 and MT5 trading platforms.* Traders must simply set two parameters:

• Calculations of the indicator which include the time period for which the moving average is needed and whether it will reflect the closing price or opening price of each measured period.
• Visual appearance of the indicator like the color and thickness of the moving average line.

How Can Moving Averages be Applied to a Trading Strategy?

Moving averages are integrated into trading strategies via two primary routes:

1. Moving Average Crossovers

The crossover between a shorter-term moving average and a longer-term moving average is frequently used by technical traders to generate “buy” or “sell” signals. The idea is that when a crossover between a relatively shorter and a longer average takes place, it demonstrates that the trend of the market has changed. For example, a crossover between a 3 SMA and a 5 SMA on the hourly charts can be a helpful signal for day traders, while swing traders with a longer-term view more often focus on crossovers between a 5-day SMA and a 20-day SMA.

2. Support-Resistance

Moving averages can also have this uncanny ability to act as areas of price support during an upward trend, and resistance zones in a downward trend. Whenever prices approach a previously respected moving average, a continuation is more likely to materialize, offering traders a potentially lower risk entry point in the direction of the ongoing trend. For example, traders visualizing short-term uptrend may find price support levels at the 20-period moving average, while a longer-term bullish trend may see buyers step in at the 50-period moving average.

What Are the Benefits and Drawbacks of Moving Averages?

Pros

• Moving averages ensure that a trader maintains a view towards the broader market trend.
• Moving averages may act as an excellent gauge of a trend reversal.

Cons

• Moving averages are lagging indicators because they are calculated based on past price data. The longer the moving average, the greater the lag.
• Moving average crossover strategies do not necessarily work well during range-bound (horizontally trending) markets.

A Final Few Thoughts on Moving Averages

The moving average is a widely-applied trading concept. Many consistent investors are trend followers and use some variation of the moving average indicator to help locate markets that have a higher probability of generating strong directional price moves. However, users should always beware of the risks of using historical data to predict future price behavior.

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*The MT5 trading platform is not currently available to UK traders.