Understanding Moving Averages in Trading

There are a number of tools an investor can use to help gauge the future direction of the market. Many of these tools can be used to help with entry and exit points, as well as, determining the direction of a trend. One of the most versatile tools is a moving average which can be used to find support and resistance levels, as well as, help pin point the direction of a market trend. Moving averages reflect the mean over a specific period of time and are helpful in painting a picture of where the market has been. From this standpoint, moving averages are depicted as lagging indicators, but they can be very helpful in designing numerous types of trading strategies.

A moving average is the average of the prices of an asset over a specific period of time. For example, if you are defining a 10-day moving average, you would calculate the average of the last 10-days and on the 11^th day you would drop the first day in the calculation. The calculation of a 10-day moving average requires at least 10 specific prices. There are also many types of moving average. The 10-day moving average which was just described is a simple moving average, but many traders also use exponential moving average as well as geometric moving averages.

An exponential moving averages attempts to reduce the lag by applying more weight to recent prices. The weighting that is added or subtracted from the most recent price depends on the number of periods in the moving average. Calculating an exponential moving average takes three steps. First, you calculated the simple moving average. Second, calculate the weighting multiplier. This is the variable that changes the more recent prices. Third, calculate the exponential moving average.

Moving averages are commonly used by technical analysts to designate areas of support or resistance. The chart below shows the 50-day simple moving average in red and the 50-day exponential moving average in green. The picture reflects the difference between the two moving averages showing that the exponential moving average reacts more quickly to recent changes to the underlying assets.

Moving average can be very helpful in determining support and resistance levels. Resistance, once broken, becomes support. And conversely support, once broken becomes resistance. Support is defined as an area where there is demand for an asset and buyers are willing to purchase a security at this level. Prices have a difficult time moving below support levels. Resistance is defined as areas of supply where prices are having a difficult time moving higher. A moving average is often used as the fair value of a security’s price. Moving averages designate the current trend of a market, but are considered a lagging indicator, as they essentially tell you what has happened in the past.

One of the most efficient ways to find a trend is to use multiple moving averages. Many traders use the crossover of a short term moving average either above or below a longer term moving average to designate a trend. Additionally, some traders use the actual direction of the trajectory of a moving average to determine the trend. For example, if a short term moving average (such as a 5-day moving average) is moving higher at the same time a long term moving average (such as the 20-day moving average) is moving higher, then the trend for that security is upward sloping. The reverse can be said for a down trend.

A popular signal that is used with moving average is a moving average crossover strategy. This strategy pinpoints the middle of a trend when a shorter term moving average crosses either above or below a longer term moving average.

If the chart above of gold prices, you can find specific periods where the 5-day moving average is either crossing above or below the 20-day moving average. This type of analysis shows you when a short term trend is in place. It can be very helpful when a trend actually perpetuates, but in many cases it occurs when the market is consolidating. Trades might be considering layering another tool to determine if the crossover is a true signal. When the 5-day moving average crosses above the 20-day moving average a short term up trend is considered in place. When the 5-day moving average crosses below the 20-day moving average a short term downtrend is considered in place.

Some trades use the signals as risk management tools as well. For example, if you entered into a trade when the 5-day moving average crossed above the 20-day moving average, you would hold that positive until the 5-day moving average crossed below the 20-day moving average, and here you would reverse your position to a short position.

In closing, a moving average is an excellent tool to use to help you design a trading strategy or evoke risk management. There are also multiple types of moving average, from the simple to the exponential which adjusts for the lag embedded in a moving average. Moving average are very helpful in determining support and resistance levels, which can be used for risk management as well as entry into a trade. Moving average can also be used to design trend following strategies such as the crossover which employs a short term and long term moving average.

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