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How Moving Averages Can Simplify Your Trading

If you’ve ever looked at a stock chart before you’ve likely already encountered these things called moving averages. They’re the most common indicators technical traders include on their charts and they’re used to assist in analyzing price. They come in all colors, exist on all time-frames, and move in a variety of speeds.

Throughout this article we are going to explore, from start to finish, how moving averages can make your life easier as a trader while also pointing out their limitations.

 

DEFINITION of ‘Moving Average – MA’

A widely used indicator in technical analysis that helps smooth out price action by filtering out the “noise” from random price fluctuations. A moving average (MA) is a trend-following or lagging indicator because it is based on past prices. The two basic and commonly used MAs are the simple moving average (SMA), which is the simple average of a security over a defined number of time periods, and the exponential moving average (EMA), which gives bigger weight to more recent prices. – Investopedia

 

How Moving Averages Are Calculated

Before we get into the good material and discuss how these indicators can help us understand price action or make trading decisions, we need to dive into a little math so we can understand how they’re calculated. Let’s start with the simple moving average (SMA).

Simple moving averages are the arithmetic mean of the past x number of closing prices.

For example, let’s say we want to plot the 5 day simple moving average of stock xyz. In order to compute that, we need to know the closing prices of the past 5 trading days.

Let’s assume they are as follows: 23, 23.2, 22.5, 24, 26

Now just sum up these prices and divide by 5 to compute the 5 period SMA.

(23 + 23.2 + 22.25 + 24 + 26) / 5 = 23.69

As new data points come available the oldest value is dropped and the newest is put in it’s place. Hence the term moving average as the data set is constantly changing.

Exponential moving averages (EMA) are a bit more complex because they place a weighting on recent prices. In order to calculate an EMA there are two pieces of data we need to know.

  • The value of the simple moving average (SMA)
  • The weighting coefficient based on this formula: (2 / (Time periods + 1) )

With those two pieces of information, we can then determine the EMA value by using this formula: {Close – EMA(previous day)} x multiplier + EMA(previous day).

Here’s how to go about calculating our 5 period EMA:

  • Value of 5 period SMA =  23.69
  • Multiplier = (2 / (5 + 1) ) = 0.333
  • EMA = (Close – 23.69) * 0.333 + 23.69

You can see in order to compute the actual value we would need to extend our price data from the above example with another 5 or so data points. We’ll skip carrying out those exact calculations, but everything you need to know to compute it on your own is listed above.

Because the EMA formula starts with a SMA value, you really need more data to begin getting the full effects of exponential weighting versus the simple values. Also keep in mind that the most recent data gets the greatest weighting and each price value going back in time decreases exponentially, hence the name.

The good news is that you will never need to carry out these calculations yourself. Nearly all charting software will handle the heavy lifting for you and it’s simply up to you to fill in the time period you’d like to plot. 

The most important takeaway about the exponential moving average is that it is more responsive to new information relative to the simple moving average. And it’s because of this, that most traders prefer using EMAs over their SMA counterparts.

 

How Moving Averages Can Simplify Your Trading

Deciding What Period To Use

Moving averages, both simple and exponential, can be used with any lookback period provided there is enough price data available.

Keep in mind, the quicker the moving average, the more responsive it will be to changing prices therefore, longer moving averages are considered more reliable trend indicators.

The specific period moving average is completely up to you to decide which works best for your needs and style, but if you can’t decide, here is a list of the more commonly used moving averages out there.

  • 20 day: averaging prices over roughly the last month, this is one of the more common fast moving averages, and is used by most active traders.
  • 50 day: the most common moving average out there and is largely considered the king of determining which stocks are in a healthy uptrend versus those which are not.
  • 100 day: similar to the 50 day, it’s longer duration is said to have more reliable trend strength, therefore making it a reliable area for support and resistance.
  • 200 day: averaging 40 weeks of price data, this is often seen as the last line of defense for long term trends to find support at, else be considered broken and/or in a bear market

Just remember, none of these specific moving averages possess special signaling or predictive powers. They are simply averaging price over various time horizons. Some will appear to work better than others within different market environments. It’s up to you to apply them so they can add value to your trading.

 

Benefits of Using Moving Averages

Now that we understand how moving averages are calculated, let’s discuss why we would include these indicators on our charts.

First, it’s important to remember that moving averages are a lagging indicator.

They lag because they use past price data to derive their values. This means they are not good at predicting future prices, rather they’re designed to help describe the current behavior of price.

Despite not having any special predictive powers they still offer plenty of value and earn their place on charts. The specific application of these indicators will vary from trader to trader but we’re going to discuss the most common uses. 
 

Moving Averages Reveal Trends

Since we know that moving averages, by definition, are constantly averaging past prices, we can analyze the slope and direction of the moving average itself to give us a quick way to interpret the current trend (or lack thereof) in the underlying instrument.

If a moving average is rising, you can safely assume that recent prices have been rising as well. But it’s not just the direction of the moving average that is important, but also the slope, or rate of change of the moving average that can reveal information about the underlying instrument.

Sharp sloped Strong momo MA Branded

A sharply rising moving average is telling a story of strong momentum, urgency, and clear direction. On the other hand, a flat or sideways moving average warns of indecision, range-bound behavior, and general chop.

How Moving Averages Can Simplify Your Trading, in this article we are going to explore, from start to finish, how moving averages can make your life easier as a trader while also pointing out their limitations.

By simply glancing at the recent behavior of moving averages, we can learn a great deal about the underlying instrument, and avoid going into a laboring process of analyzing price action. 
 

Moving Averages Smooth Out The Noise

Price action isn’t always clean. Sometimes stocks undergo a series of gaps, trade erratically in a range, or just flat out act unpredictably. When this is the case, moving averages can help make sense of otherwise unclear markets.

A great way to gain an objective view of a market is by completely removing the price series data from your chart and only plotting moving averages.

It’s remarkable how quickly you can understand the story of the chart when you drop off noisy price data and only plot moving averages.

IWM_messy

Look how noisy the above chart is. It’s hard to tell what’s going on with all of the overlapping price action and back and forth trading. Compare this to our next chart.

IWM_Just_clean_MAs

This is the same exact chart, only this time we’ve hidden the price series data, and only displayed the 20 period exponential moving average. Look how clean and easy to understand this chart is by comparison.
 

Moving Averages Help With Entry & Exit Signals

While it may seem overly simplistic, there are plenty of trading systems out there that use moving averages to generate entry and exit signals.

For example, a simple system could be designed to take a long trade when the 20 day moving average crosses above the 50 day moving average and then exit when the 20 day crosses back under the 50.

AAPL_cross_over_under

This specific system may not be all that profitable on its own, across all market environments, but it can easily be the backbone to a strategy that incorporates additional technical studies to help with accuracy and efficiency.
 

Moving Averages Act As Support & Resistance

Because some moving averages are so widely used amongst technicians it is often said that the averages themselves act as natural support or resistance.

We observe this most often when stocks get near the heavyweights like the 50 day or 200 day moving averages.

NFLX_50MA_support

 

How Moving Averages Simplify My Trading

Moving averages are the only indicator you are guaranteed to see on my charts at all times. They are essential in both saving me time quickly identifying how a stock has been behaving, as well as playing a critical role in my trading strategy.

I am a momentum trader, which means I trade stocks that are accelerating higher relative to recent prices and I exit the trade before it’s given too much of that move back.

Because my goal is to effectively capture a single leg within a trend, I’m not all that interested in looking at longer-term moving averages.

A 200 day moving average or a 50 day is irrelevant to me when my hold time is expected to be a week or less. I’m not saying those moving averages don’t work or shouldn’t be used, they’re just not part of my specific trading framework.

I use two moving averages, the 8 period EMA and the 20 period EMA.

When the 8 period EMA is rising and accelerating away from the 20 period EMA, this satisfies my underlying condition of a stock exhibiting strong momentum.

By using these specific moving averages, I can quickly find and identify the exact type of stocks that are worth paying attention to.

For me to even consider getting long a stock, it has to be in what I consider bullish alignment. Bullish alignment means price has to be above the 8 period EMA and the 8 period EMA has to be above the 20 period EMA.  

How Moving Averages Can Simplify Your Trading

Compare the above bullish aligned chart setup with the one below which is not in bullish alignment:

X_rally_without_bullish_alignment

There are other counter-trend reversal setups that I trade which don’t require bullish alignment, but for breakouts, pullbacks, and potential trend trades, I am always looking for the above alignment to be satisfied.

There are many other ways to implement and utilize moving averages but I hope this article has at least given you a starting point to simplify and improve upon your own trading process.

If you have any thoughts you would like to share, or insights into how moving averages simplify your trading, I would love to read about it in the comments below.
 

12 comments on “How Moving Averages Can Simplify Your Trading

  1. While I knew most of what the article provided , I must compliment the author for making this dummy proof !
    It’s cogent , well written and it can be understood by anyone and everyone .
    Even if one has no knowledge of the Market, the reader will walk away feeling empowered by having this knowledge in their back pocket and should they choose to trade , these tools will have come handy and allow one to be a succinct trader which is a lot better than shooting darts at the board and picking up the ticker in that manner! A strategy that could have been applied in 2012 to 2014 .
    Well done mate !

  2. This is a really good guide to moving averages. I personally like using them for pullbacks. I find they are more effective than crossovers. The setting of 5 EMA and 50 SMA works best for me and in generally in tests it has been confirmed that those are good for short term trading. What do you think about mt4trendindicator that is based on moving averages and ADX. Do you think that’s a good combo?

    1. Thanks for the comment and adding to the discussion Pete. Not familiar enough with the mt4 system to have an opinion but certainly seems reasonable. I’ve seen similar strategies have promising results.

  3. Thanks for your help with moving averages. I’ve just got into technical analysis and you make it look easy.
    Last financial year I made about 60 k only to see it get drained from my account towards the end. Hopefully technical analysis can help to prevent this happening again
    Thanks again
    Mark

    1. Sorry to hear about the losses at the end of the year Mark. I think technical indicators, just like moving averages can be a great tool for mitigating risk across trading systems. Good luck moving forward.

    1. Hey Brian, Absolutely.

      While I don’t personally trade FX, I know many traders who do, and they use moving averages for the core concepts discussed in this article.

      In fact, FX markets are often said to be even more responsive and influenced by major technical indicators like moving averages.

      Good luck!

  4. Evan thank you so much. I started 1.5 months ago trading penny stocks in my TDAmertrade account. I just started reading your reports.
    For someone who has zero knowledge of technical talk I really clearly understand what you are teaching and learning more how to fit into this pursuit to make money. I like simple and clear talk. That is what I gain here. Can’t wait to apply the MA knowledge you gave me.

    1. Hey John,

      Fantastic to hear, thanks for commenting I’m glad the blog has been helpful for you. Keep up the good work, keep learning, and feel free to reach out if I can be of any help.

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