Usage of Moving Averages in Trading

Usage of Moving Averages in Trading

Average is a word that we all have acquainted with. We all have learnt the topic of averages in school and the moving average is considered as an additional version of it.

As we all know, calculating averages become an integral part of our lives as it is the fundamental term used to express the central or typical value in a set of data particularly the mean, median or mode.

Now, you may be interested to know that moving averages can also be used for trading. Before we take a dig deep into moving averages and how it adds a value in the stock market trading, let’s get a brief of the term.

Moving Averages are trend indicators that are widely used to predict future stock price trends. They are mostly used because of their simplicity and effectiveness.

The most common moving averages are 15-, 20-, 30-, 50-, 100- and 200- day MA.

Types of Moving Averages

There are mainly two types of moving averages used in trading, which are SMA (Simple moving average) and EMA (Exponential Moving Average). The SMA is calculated as: take the closing price of a security for the relevant period, add them and divide the sum by the period number.

Where in EMA, each price in the MA is given an equal weightage. Also, the calculation of EMA is more complex than SMA as it gives more weightage to the most recent price.

Using Moving Averages:

The moving indicator records the data based on the past price trends and hence it is known as the lagging indicator. I.e the longer the moving average time period, the greater the lag. A 200-day MA is lagging more than a 20-DMA because a 200-DMA is plotted based on the past 200 days. Whereas the latter is plotted by using the latest 20 days data.

You can easily customize the MA indicator. The shorter the MA, the more effectively its price changes. 

Below we are mentioning a few points on using moving averages:

    • An upward and downward Moving averages can tell you many things. A rising MA tells a security price rising upwards, whereas the downward moving averages indicate a security price trending downwards.
    • Traders use both types of Moving Averages i.e Upward MA and downward MA.
    • To track the effective time period that works best for your stock, you are required to experiment with multiple time periods of moving averages.

How Moving Average is used to spot trending directions?

When a stock trends upwards, its moving average will act as a floor price.

When a stock trend downwards, the moving average will form a resistance with the stock price which is currently going downwards.

Moving Average Convergence Divergence

You can also plot two or more MAs for stock to detect crossover i.e the point at which Moving Average intersects each other.

This brings us to the moving average convergence divergence (MACD). The MACD is calculated as the difference between a stock’s two EMAs – the 12 periods and 26 periods EMA.

Now, explaining the MACD signal line – a nine period EMA of the MACD value. When plotted over the MACD line, it acts as a trigger to buy or sell.

It is a buy signal when the MACD crosses the above signal line, it is a sell signal when it crosses the below signal line.

Crossover Trading Strategies

Price Crossover

Price crossover is defined as a cross over above or below the Moving Average, its immediate mark a change in stock’s price trend.

MA Crossover:

Two Plotted MAs are bound to crossover at various points. A comes were the short term MA crosses above the long term MA signifies a bullish pattern.

When the short term MA crosses below the long term MA, it indicates a bearish pattern.

200 Day Moving Average Strategy

If the stock price counted above 200 days MA, it marks a buying trend whereas if a stock price comes below 200 days MA, it gives a sell indicator.

Moving Average Disadvantages

Moving averages are calculated based on the past trends and it shows nothing about prediction based on present trends. Hence, the results using moving averages can be random. There is a time where the markets support MA/resistance and trade signals, while at other times the results are different than what MA shows.

Another Problem is Price fluctuation. 

If the price action changes frequently and it swings forth and back generates multiple trade signals, it confuses the MA.

At this point, it’s good to seek another trading indicator to clarify the trend.

The same thing happens with MA crossovers when MA gets tangled up for a period of time which in turn results in multiple trading losses.

Moving averages work well when the trending conditions are strong but fail in choppy or ranging conditions. The best solution is to adjust the time frame that can solve this problem temporarily. However, at some point in time, these issues frequently occur regardless of the time frame chosen for the Moving Averages.

The Bottom Line

A moving average simplifies price data that can be used by monitoring past trends. It has been observed that EMA reacts quicker to price changes than SMA.

In some cases, it gives a good response to the research while in some cases it gives the wrong signal. Moving averages with a shorter lookback period (20 days) will also give a faster response to price changes than an average with a long lookback period i.e 200 days.

Moving averages crossovers is still a popular strategy for both entries and exits. MAs can also highlight areas of potential i.e. support or resistance.

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