Moving Average Trading Strategies

by Amanda Harvey

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Introduction

Moving average trading techniques involve the use of moving averages, both as a stand-alone indicator, and also as the basis for more complex indicators such as the MACD, Moving Average Envelopes, and Bollinger Bands. A moving average is a calculation of the average price of a security over a certain period of time, and as the name implies, this average moves or changes from one period to the next. One of the advantages of using a moving average rather than raw price data is that the average has the effect of smoothing out the day to day fluctuations in price, and thereby providing a clearer picture of the general trend in price movement.


The Simple Moving Average

There are a few different types of moving averages, and the most basic of these is the simple moving average, abbreviated to SMA. The simple moving average may be calculated for various time frames, from lengths as short as a couple of periods, to durations of 200 periods or more. Moving averages may be calculated using periods of days, weeks, or months, depending on the trader’s goals and requirements.

The SMA is calculated simply by adding the closing prices for the security for each period of the selected time frame, and then dividing the total by the number of periods. For the following period, the first period from the previous period’s moving average is dropped, and the latest closing price is added in its place and the average is recalculated.

The simple moving average gives equal weight to all periods, whether they are recent or not. It is suggested that the most recent prices are more relevant than those from some time ago, and that giving equal weight to less recent prices causes the average to lag further in relation to the actual prices.

The Exponential Moving Average

The exponential moving average (EMA) addresses the concern that a simple moving average is apt to lag more than a trader may prefer due to the equal weighting of all prices. The EMA gives greater weighting to more recent prices allowing the average to keep pace better with the actual price movement.

A shorter time-frame EMA applies the greatest weighting to the most recent price. For example, a 10-period EMA gives an 18.18% weighting to the latest price. This weighting factor is reduced proportionately based on the number of periods used in the average, meaning that a lengthy EMA will only add minimal weighting to the most recent price.

Moving Average Trading Points to Consider

In the application of moving average trading strategies, one thing to keep in mind is that the shorter the time frame of the moving average, the faster it will respond to changes in price movement. A longer moving average takes more time to reflect price changes.

A key point in using moving averages is that they allow the trader to see a developing trend more clearly, as they eliminate the much of the distraction created by the natural ups and downs that occur regardless of which way prices are moving.

It is also important to be aware that a moving average is a lagging indicator, meaning it moves behind the prices, acting as a confirmation, rather than indicating a probability of something yet to happen. This is a natural result of that fact that the moving average indicator is based on historical price data.

Moving Average Trading Signals

The most commonly used moving average trading signal is known as a ‘crossover,’ which is evident when the moving average line crosses the price line. When the price crosses below the moving average line, this is often interpreted as a signal that the prices are poised to drop further. Conversely, the price crossing above the moving average line may present an indication of an impending move upward.

Another moving average trading method is to apply two moving averages of different lengths to a price chart. A signal known as a ‘golden cross’ is formed when the line of the shorter moving average crosses above the line of the longer moving average. This is interpreted as an indication that the trend is shifting upward, and presents an opportune time to buy.

In contrast to the golden cross, another type of cross is formed when the shorter moving average line crosses below that of the longer moving average. This cross is termed a ‘death cross,’ and represents a sell signal in the likelihood of a downward shift.

In Conclusion

Moving average trading strategies can include the use of both simple and exponential moving averages as an easy to calculate and visually clear and informative method of assessing trends. Moving averages can also be applied to price charts singly or in pairs in order to obtain crossover signals, which present indications of opportune points at which to buy or sell. There are also many popular technical indicators which incorporate the use of moving averages in their calculations. Overall, moving averages are one of the simplest, most popular, and most effective trading tools available to anyone seeking to create effective trading strategies.


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