Moving Averages Explained
Moving averages (or MA’s) can be one of the easiest technical analysis indicators to understand and utilize. MAs get a lot of media exposure, yet many investors and traders are generally unaware of their full range of use. MAs can be beneficial to both long and short-term trades, as they can provide warnings, in addition to entry and exit indications, which in turn simplifies market data for you.
While moving averages and moving average crossovers (which I’ll discuss in a minute) are highly beneficial tools, trading with technical analysis involves uses multiple indicators and examining the big picture of the current trend. That being said, don’t rely on just moving averages. Use them in tandem with other tools to confirm price action.
The Difference Between the Simple and Exponential Moving Average
Two of the most commonly use moving averages are the simple and exponential. Each is calculated a little differently. As an example, a simple moving average (SMA) for the last 10 days tallies the closing prices for the prior ten days, and then divides that total by ten. The exponential moving average (EMA) does the same, but with an added “multiplier” that gives the most recent prices more weight. Because more weight is added to recent prices, the EMA has the tendency to react quicker to price action than the SMA as you can see from the example of BBRY below.
The data that a moving average is based on could come from a daily bar (as it did in the example above) or it could come from any other time period. If you’re looking at an hourly chart, the MA will be calculated based on hourly price data. If using a 30-minute chart, the MA uses the price data from 30 minute candles… and so on.
So Which Moving Average is Better?
It depends on how you trade. Short-term traders want to enter and exit trades at the most opportune time. For short term trades (minutes, hours, days), you want your MA to react quickly to the current conditions of the market. For this reason, short term traders prefer the exponential moving average.
Investors and long-term traders don’t want or need as many trade indications. As a result when trading long-term trades (weeks, months, years), a simple moving average that reacts slower to short-term price action is usually preferred.
The most popular moving averages are the 5, 10, 20, 50, and 200. Each of these MAs appeals to different traders and investors. Day traders are also known to utilize a 20 or 5 period MA, where the MA could be applied to a 1 or 5 minute chart.
Investors and long-term traders tend to monitor the 200 day SMA, as they are generally only concerned with the overall direction of the market. A 200 day MA is slow to react to fluctuations or volatility in the market, as it filters out of a lot of the “noise” and displays the long-term overall market trend.
Dynamic Support and Resistance
Support and resistance levels are commonly known as horizontal lines or diagonal trend lines that support or resist price action. Dynamic support and resistance is a little bit different.
I first want to note that dynamic support and resistance is not as indicative or as strong as price developed horizontal and diagonal support and resistance. Again, other indicators in addition to moving averages should be analyzed to confirm price support or resistance. That being said, MAs certainly have their benefits.
Dynamic support and resistance levels are found where a moving average converges with the current price. So let’s take another look at BBRY, this time the 50 and 200 SMAs on a daily chart.
Notice how both the 50 and 200 MAs appear to be providing both support and resistance? Also take note that this isn’t 100% reliable, and that MAs are crossed on a daily basis for hundreds of tickers.
Now lets look at the same ticker and time period, but with the 10 day added (in blue). Notice the dynamic support and resistance of the 10?
Keep in mind, that the longer the time period, the stronger the support and resistance. Look at it like the 50 is the 10’s big brother, with the 200 being the oldest, biggest, and strongest sibling.
Which Moving Averages Are Most Important?
Long-term investors, in addition to swing traders, tend to monitor the 50 day SMA. This MA reacts quicker than a 200 day MA, and is useful for spotting medium-term trends, while the 200 is generally focused on the long-term trend.
Swing traders mostly focus on short-term trends, as they prefer to enter and exit a trade within days or weeks. These traders tend to use a 5, 10, or 20 day SMA or EMA or combination of several. However, note that monitoring the 50 and 200 can assist in signaling a bounce or a multi-month breakout or breakdown. Don’t avoid them, embrace them.
The chart below shows BBRY again, this time with the 5, 20, 50 and 200 day moving averages.
The shorter the time period of the MA, the closer it tracks price action. The 200 day MA shows the overall trajectory of the price, while the shorter averages track smaller price trends.
Moving Average Crossover Strategies
When the price of a stock crosses a moving average, its known as a price crossover. The average trader uses at least 2 (or more) MAs to monitor averages. This creates an additional type of crossover, which happens when one MA crosses another, like the 50-day crossing the 200-day.
When the price of a stock crosses a moving average, it signals that a change in the current trend may have began within that time frame. As a result, traders throughout the world view price crossovers as significant events.
Based on the time frame of the MA being monitored, it could be that the change in trend actually occurred at an earlier time. This is often the case with longer time frames like the 200. Regardless of the time frame used, the price crossover still helps to confirm the reversal in trend.
Bullish Price Crossover
A bullish crossover occurs when the price crosses a moving average to the upside. This action in price indicates that a reversal of the downtrend (for that time frame) may be over and an uptrend could be beginning.
If found within trending markets, this indicator can be quite reliable, as shown below with TWTR.
In sideways or choppy markets a bullish crossover may be less meaningful, since there is no established significant trend present in either direction.A 50 day MA is a useful tool to re-enter medium to long term trades when the trend resumes, in addition to being used to exit trades. Whether long or short term, trade direction should align with the overall market trend. As an example, during a long-term bullish trend upward, traders should focus on buying bullish crossovers.
However, during a long term bearish downtrend, bullish crossovers are less significant. A 200 day MA can be utilized to determine the overall direction of the trend.In a daily chart of AAPL below, the overall trend is bullish, as indicated by the price staying well above the 200 day MA. However, on a few occasions, it drops below the 50 day MA.
When the price cross back above the 50, its considered a bullish crossover, and a signal to buy. There are numerous exit strategies, but one involving MAs is to close the position when a candle closes below the MA.
A flaw found with the bullish crossover strategy is that it doesn’t always mean that a trend is going to continue in the direction of the crossover to the upside.
Bearish Price Crossover
A bearish crossover occurs when the price cross over a moving average to the downside. This indicates a possible change in direction for the averaged time frame. A bearish crossover can be utilized as an indication to exit long positions, or could be used as a signal to enter short positions as shown below.
Similar to a bullish crossover, during sideways or choppy market, a bearish crossover is less meaningful due to no trend in either direction being present.
MA Crossovers occur when 2 (or more) moving averages of different time frames are utilized, and one crosses the other. Moving average crossovers are referred to as a “golden cross” or a “death cross”, based on the direction of the crossover. Similar to price crossovers, MA crossovers can also be defined as bullish and bearish crossovers.
A golden cross occurs any time a shorter MA crosses above a longer-term MA. This indicates that the recent trend is moving higher and is an indication to buy. As long-term indicators carry more weight, the golden cross indicates a change in sentiment to the bullish side on the horizon and is reinforced by high volume trading. In addition, the long-term MA becomes the new dynamic support in the rising market.Traders that utilize technical analysis may see the golden cross as an indication that the market has turned in the ticker’s favor. Trades are only played ideally in the direction of the long term trend. If the overall trend is upward, golden crosses are referred to as buying indicators.
The most popular golden cross scenario, which is often referred to in the media, is when the 50 day MA crosses above the 100 day or 200 day MA. This indicates that the long term downtrend may be coming to an end, and an new uptrend has potentially began.
If you’ve been trading at all recently, you may remember VLTC and it’s epic run from less than $1 to $21 in a matter of days. Had you been monitoring the 50 and 200 MAs, you may have caught most of the move before it happened. Due to the daily MAs running so tight together for so long, swift price action drives the 50 up quickly, and a cross occurs earlier in the pattern.
Keep in mind, that if trading short term, the golden cross should be utilized on a shorter time frame, like a 5 or 15 minute chart. There are times the golden cross will not appear until after the major move has concluded, due to distance between the MAs prior to the move.
In the example using UA below, the golden cross occurred in May of 2013 at around $26 per share. By May of 2015, the price reached the high 90’s. If you would have bought and sold based on the MAs, you would have made more than simply holding the entire time.
A death cross occurs when a shorter MA crosses below a longer-term MA. This indicates that recent price action is moving lower and is considered an indication to sell or short the stock. The example shown below is a 5 minute chart of RAD, that highlights both golden and death crosses, and explains how a day or swing trader could utilize MAs in shorter time frames.
Since the 100 and 200 MA are commonly used to determine the long-term trend, when a 50 day MA crosses below it, it signals that a significant downtrend is already established. When this indication occurs, long positions should be exited and short positions should be taken.
Triple Crossover and the Moving Average Ribbon
More MAs can be added to a chart to increase the validity of the buy or sell indication. Many traders will use a 5, 10 and 20 MA on a chart, and wait for a buy signal when the 5 MA crosses the others to the upside. The 10 MA crossing the 20 to the upside is considered to be confirmation, a strategy that often reduces the overall number of false indications. I’ve included an example below, again with RAD on a daily chart.
By involving more than 2 MAs, as with the triple crossover method, is one of the best ways to measure the strength of a trend and the probability that the trend will continue.
So what would be the result if you kept adding MAs? Some people argue (consistently and passionately) that if one MA is useful, then the more you have the better. Which leads us to the moving average ribbon.
As displayed in the chart for Sprint below, several MAs are placed on the same chart and are monitored to evaluate the overall strength of the current trend. When all the MAs continue to move in the same direction, the trend is considered to be strong. Reversals in trend are confirmed when the MAs cross over and head in the other direction.
Moving averages can change the way you trade. Harness their power, and practice using them on your every day charts. You’ll be surprised how fast you are able to pick it up, and how good of an indication tool they really are.
Have you had success trading with MAs? Did you learn something about MAs? If so, please leave a comment or share the knowledge with others through Facebook or Twitter.