Moving Averages Explained
Moving averages (or MAs) 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 traders, 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 using multiple indicators and examining the current trend’s big picture. 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 Averages
Two of the most commonly used moving averages are simple and exponential. Each calculates a little differently. For 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 tends 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 moving average calculates using hourly price data. If using a 30-minute chart, the moving average uses the price data from 30-minute candles… and so on.
Moving Averages: Which 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 moving average to react quickly to the market’s current conditions. 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 better.
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 market’s overall direction. 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 or diagonal trend lines that support or resist price action. Dynamic support and resistance are a little bit different.
I first want to note that dynamic support and resistance are not indicative or as strong as price-developed horizontal and diagonal support and resistance. Again, other indicators and 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, note that this isn’t 100% reliable and that MAs break daily for hundreds of tickers.
Now let’s 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 help signify a bounce or a multi-month breakout or breakdown. Don’t avoid them; embrace them.
The chart below shows BBRY again, with the 5, 20, 50, and 200-day moving averages.
The shorter the MA’s time period, 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 a stock’s price crosses a moving average, traders call this a price crossover. The average trader uses at least 2 (or more) MAs to monitor averages. This creates an additional crossover type, which happens when one MA crosses another, like the 50-day crossing the 200-day.
When a stock’s price crosses a moving average, it signals that a change in the current trend may have begun within that time frame. As a result, traders worldwide view price crossovers as significant events. May consider these crossovers as a 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. Whether long or short-term, trade direction should align with the overall market trend. For 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 determines the overall direction of the longer-term 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, it drops below the 50 day MA on a few occasions.
When the price crosses back above the 50, this is a bullish crossover and can be 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 will 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 an indication to exit long positions. It can also be a signal to enter short positions, as shown below.
Like a bullish crossover, a bearish crossover is less meaningful during a sideways or choppy market due to no trend in either direction being present.
Moving Averages – Crossovers
Moving average crossovers occur when 2 (or more) moving averages see one moving average cross above/below the other. Like price crossovers, MA crossovers can be bullish or bearish crossovers.
Moving Averages – Bullish Crossover
A bullish crossover occurs when a shorter moving average crosses above a longer-term moving average. This indicates that the recent trend is moving higher. As long-term indicators carry more weight, the bullish crossover indicates a change in sentiment to the bullish side and confirms with high volume trading.
The long-term moving averages become the new dynamic support in the rising market. Ideally, open trades occur in the direction of the longer-term trend. If the overall trend is up, bullish crossovers can be buying indicators.
The most popular bullish crossover is when the 50 day MA crosses above the 200 day MA. This is referred to as a “golden cross.” It indicates that the long-term downtrend may be coming to an end, and a new uptrend may be starting.
You may remember VLTC and its epic run from less than $1 to $21. 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 drive higher.
If trading shorter term, you should be watching for these bullish crossovers on shorter time frames. Perhaps the 5 or 15-minute chart. There are times a bullish crossover will not appear until after the major move has concluded due to the distance between the MAs before 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, price is in the high 90’s. If you had traded hits exampled based on the moving averages, you would have profited nicely.
Moving averages – Bearish Crossover
A bearish crossover occurs when a shorter moving average crosses below a longer-term moving average. This indicates that recent price action is moving lower and can be an indication to sell or short the stock. The example shown below is a 5-minute chart of RAD. It highlights both bullish and bearish crossovers and explains how traders can effectively use moving averages on 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 present. When this indication occurs, consider exiting long positions and/or entering short positions.
Triple Crossover and the Moving Average Ribbon
You can add more MAs to a chart to increase the buy or sell indication’s validity. 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 confirmation, a strategy that often reduces the overall number of false indications. Again, I’ve included an example below 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 a trend’s strength 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, the more you have, the better. Which leads us to the moving average ribbon.
As shown on Sprint below, several MAs are on the same chart to evaluate the current trend’s overall strength. When all the MAs continue to move in the same direction, the trend is strong. Reversals in trend confirm when the MAs crossover and head in the other direction.
Moving averages can change the way you trade. Harness their power, and practice using them on your everyday charts. It may surprise you how fast you can pick it up and how good of an indication tool they really are.
Charting platforms like TradingView offer countless moving average indicators that you can customize as you see fit. Ribbons, crossover indicators, all kinds of cool indicators that anyone can use. Check them out if you’re not happy with your current platform.
Have you had success trading with MAs? Did you learn something about MAs? If so, please leave a comment or share this post with others.