Moving averages are among the most widely used and powerful technical indicators available. In this article we’ll cover how they can help you determine the trend direction, how they can be used as support and resistance levels and how they can be used as trade entry and exit signals.
What are Moving Averages?
Moving averages smooth out price data over time, removing noise and making the directional trend clear. They are formed using the average closing price over a set number of periods. For example, a 10-day simple moving average is the ten-day total of closing prices divided by ten.
Because they are based on past prices, moving averages lag current price action. The longer the time period for the moving average, the greater the lag.
The most commonly used moving averages are the Simple Moving Average (SMA), which is the simple average over a defined number of time periods, and the Exponential Moving Average (EMA), which gives greater weight to more recent prices.
Simple Moving Averages Vs. Exponential Moving Averages
SMA’s are slower than EMA’s to respond to price action. They are slower to indicate trends or trend reversals but they are less prone to false signals.
In order to catch trends early it is best to use a short period EMA. The downside to using the exponential moving average that they will give you more false signals during consolidation periods. The SMA will give more reliable signals but since it is slower, you will get the signals later.
Using several different moving averages will give you a broader outlook. For example a trader might choose to use a longer period simple moving average to understand the broader trend, and a shorter period exponential moving average for entry signals. Simple moving averages may better identify support and resistance levels since they reflect a balanced average of prices for the set period.
How to Use Moving Averages to Determine the Trend
Broadly speaking, when price action stay above a moving average, it signals that price is in an uptrend. Coversely, if price action remains below the moving average, then it indicates a downtrend.
It can be helpful to use several moving averages at one time to determine the trend. Look for the lines to be in correct order (fastest to slowest in an uptrend, slowest to fastest in a downtrend) to confirm that you are in an up or down trend.
Moving Average Crossovers
Moving average crossovers can help you determine when a new trend is about to begin or an existing trend is about to reverse.
Upward momentum is confirmed with a bullish crossover, when a short-term moving average crosses above a longer-term moving average. This is sometimes called a ‘Golden Cross’. Downward momentum is confirmed with a bearish crossover, when a short-term moving average crosses below a longer-term moving average, sometimes referred to as a ‘Death Cross’.
For intraday trading shorter term moving averages could be used, for example 5 and 10 period exponential moving averages. Longer term traders might watch for crossovers of the 50 period and 200 period SMAs.
The longer the moving average used, the greater the lag in the signals. Moving average crossovers tend to work well in trending markets but not well in sideways or consolidating markets.
Moving Averages as Dynamic Support and Resistance Levels
Moving averages can also act as support in an uptrend and resistance in a downtrend. For example, a short-term uptrend might find support near the 21-day Expontential Moving Average (EMA) while a long-term uptrend might find support near the 200-day Simple Moving Average (SMA).
The 50 period and 200 period Simple Moving Averages on the daily chart are widely followed and often represent important support and resistance levels. The 200 period simple moving average on the daily chart is sometimes described as the ‘line in the sand’. A Keep in mind that the levels are not exact and moving averages more often represent zones of support and resistance. The levels are dynamic in the sense that they are constantly changing based recent price action.
Moving averages are a multi-faceted indicator that can help you define the trend, support and resistance, when to enter, and when the trend is drawing to a close. Experiment with moving averages of different lengths and also on different time frames to determine what works best for your trading strategy.