Technical analysis (TA) is nothing new in the world of trading and investing. From traditional portfolios to cryptocurrencies such as Bitcoin and Ethereum, using TA indicators has a simple goal of using the data available to make more informed decisions that are likely to lead to the desired results. As markets become more complex, hundreds of different types of TA indicators have been created over the past decades, but few have seen the popularity and continued use of moving averages (MAs).

Although there are different variants of moving averages, their main purpose is to provide clarity on trading charts. This is done by overlaying graphs to create an easily decipherable trend indicator. Because these moving averages are based on past data, they are considered lagging or trend following indicators. Even so, they still have immense power to break through the noise and help determine where the market might be headed.

Different types of moving averages

There are different types of moving averages that can be used by traders not only in day trading and swing trading, but also in the long term. Despite the different types, moving averages are most commonly divided into two distinct categories: simple moving averages (SMA) and exponential moving averages (EMA). Depending on the market and desired outcome, traders can choose which indicator is most likely to benefit their setup.

Simple moving average

SMA takes data over a set time period and outputs the average security price for the data set. The difference between the SMA and the underlying average of past prices is that with the use of the SMA, as soon as a new set of data is entered, the older set of data is ignored. So if a simple moving average calculates an average based on 10 days of data, the entire data set is constantly updated to include only the last 10 days.

It is important to note that all SMA inputs are equally weighted, regardless of how long ago they were input. Traders who believe that newly available data are more important often claim that the equal-weighted SMA is detrimental to technical analysis. The Exponential Moving Average (EMA) was created to solve this problem.

Exponential Moving Average (EMA)

The EMA is similar to the SMA in that it provides technical analysis based on past price movements. However, the equation is a bit more complicated because the EMA gives more weight and value to the latest incoming price data. While both indicators have value and are widely used, the EMA is more sensitive to sudden price swings and reversals.

Since the EMA is more likely to predict a price reversal sooner than the SMA, it is more often chosen by short-term traders. It is important for a trader or investor to choose the type of moving average according to their personal strategies and goals, adjusting the settings accordingly.

How to use moving averages

Since moving averages use previous prices instead of current prices, they have a certain lag period. The wider the data set, the greater the lag. For example, a moving average that analyzes the last 100 days will react more slowly to new information than a moving average that only considers the last 10 days. This is simply because a new record in a large data set will affect the overall numbers.

Both indicators can be profitable depending on the trading setup. Large data sets benefit long-term investors because they are less likely to be greatly altered by one or two large swings. Short-term traders often prefer a smaller data set that allows for faster trading.

In traditional markets, moving averages with terms of 50, 100 and 200 days are most often used. Stock traders keep a close eye on the 50-day and 200-day moving averages, and any breaks above or below these lines are usually seen as important trading signals, especially when they follow crossovers. The same applies to cryptocurrency trading, but due to volatile 24/7 markets, moving average settings and trading strategies may differ depending on the trader's profile.

Cross signals

Of course, an ascending MA indicates an uptrend, and a descending MA indicates a downtrend. However, the moving average by itself is not a really reliable and strong indicator. Thus, moving averages are constantly used in combination to detect bullish and bearish crossover signals.

Crossover signals are created when two different MAs cross on a chart. A bullish crossover (also known as a golden cross) occurs when the short-term moving average crosses the long-term moving average higher, indicating the beginning of an uptrend. Conversely, a bearish cross (or death cross) occurs when the short-term moving average crosses below the long-term moving average, indicating the beginning of a downtrend.

Other factors to consider

So far, all examples have used days, but this is not a mandatory requirement for MA analysis. Intraday traders are more interested in how an asset has performed over the past two or three hours, not two or three months. Different timeframes can be included in the equations used to calculate moving averages, and as long as these timeframes are consistent with the trading strategy, the data can be useful.

One of the main disadvantages of MA is its lateness. Since MA is a lagging indicator that takes into account the previous price movement, the signals are often late. For example, a bullish cross may suggest a buy, but this can only happen after a significant price increase.

This means that even if the uptrend continues, potential profits may be lost in the period between the rising price and the crossover signal. Or worse, a false golden cross signal can cause a trader to buy at a local top just before the price drops. These false buy signals are commonly referred to as a bull trap.

Final thoughts

Moving averages are powerful TA indicators and are among the most widely used. The ability to analyze market trends based on data allows you to better understand how the market works. However, keep in mind that moving averages and crossovers should not be used separately and it is always safer to combine different AND indicators to avoid false signals.