Moving Average Explained
Technical analysis (TA) is nothing new in the world of trading and investing. From traditional portfolios to cryptocurrencies such as Bitcoin and Ethereum, the use of TA indicators has a simple goal, to use existing data to make more informed decisions that are likely to lead to the desired results. As markets have become increasingly complex, hundreds of different types of TA indicators have been developed in recent decades, but few have become as popular as the consistent use of moving averages (MAs).
Although there are different variations of moving averages, their main purpose is to provide clarity to trading charts. This is done by smoothing the charts to create an easy to decipher trend indicator. Because these moving averages are based on past data and the indicators are considered to be lagging or trend following. Despite this, they still have a great ability to overcome disturbances and help determine market movements.
Different Types of Moving Averages
There are different types of moving averages that can be used by traders not only for day trading and swing trading, but also for long-term setups. Although there are different types, MAs are most often divided into two distinct categories: simple moving averages (SMA) and exponential moving averages (EMA). Depending on the market and the desired outcome, traders can choose which indicator is suitable and will benefit from its installation.
Simple moving average
SMA takes data over a specific period of time and shows the average price of that asset for the data set. The difference between an SMA and a basic historical average is that with an SMA, as soon as a new set of data is introduced, the oldest set of data is ignored. Thus, if a simple moving average calculates the average based on 10 days of data, the entire data set is continually updated to include only the last 10 days.
It is important to note that all inputs to SMA are evaluated the same, regardless of when they were entered. Traders who believe there is more current data available often claim that equal weighting of the SMA is detrimental to technical analysis. The exponential moving average (EMA) was created to solve this problem.
Exponential moving average
EMAs are similar to SMAs in that they provide technical analysis based on past price movements. However, the formula is a little more complicated because the EMA assigns more weight and significance to recent price entries. While both averages have value and are widely used, the EMA is more responsive to sudden price swings and reversals.
Since the EMA is more likely and faster to predict price reversals than the SMA, it is accordingly chosen by traders for short-term trading. It is important for a trader or investor to choose the moving average type according to their personal strategies and goals, adjusting the settings accordingly.
How to use moving averages
Since MAs use past prices instead of current prices, they have a certain lag period. The larger the data volume, the longer the delay will be. For example, a moving average that looks at the last 100 days will respond to new information more slowly than a moving average that only looks at the last 10 days. This is simply because a new entry in a large volume of data will have less impact on the total number.
Both can be profitable depending on trading setup. Large amounts of data benefit long-term investors because it is less likely to be changed greatly by one or two big swings. Short-term traders often prefer a smaller data volume, which allows for more reactionary trading.
In traditional markets, the most commonly used MAs are 50, 100 and 200 days. Stock traders keep a close eye on the 50-day and 200-day moving averages, and any breakouts above or below these lines are usually considered important trading signals, especially when they are followed by crossovers. The same applies to cryptocurrency trading, but due to its 24/7 market volatility, MA settings and trading strategy may vary depending on the trader's profile.
Crossover signals
Naturally, an ascending MA indicates an upward trend, and a descending MA indicates a downward trend. However, the moving average alone is not a truly reliable and powerful indicator. Thus, MAs are constantly used in combination to detect bullish and bearish crossover signals.
A crossover signal is created when two different MAs cross on the chart. A bullish crossover (also known as a golden cross) occurs when the short-term moving average crosses above the long-term moving average, indicating the start of an uptrend. In contrast, a bearish crossover (or death crossover) occurs when the short-term moving average crosses the lower long-term moving average, indicating the start of a downtrend.
Other factors to consider
So far, examples have been given in days, but this is not a mandatory requirement when analyzing MA. Day traders may be much more interested in how a security has performed over the past two or three hours rather than two or three months. All time frames can be included in the equations used to calculate moving averages, and if those time frames fit the trading strategy, the data can be useful.
One of the main disadvantages of MAs is their latency time. Because moving averages are lagging indicators that take into account previous price behavior, signals are often late. For example, a bullish crossover may suggest a buy, but this occurs only after a significant increase in price. This means that even if the uptrend continues, potential profits could be lost during this period, between the price increase and the crossover signal. Or, even worse, a false gold cross signal can cause a trader to buy just before the price falls (these false buy signals are usually called a bull trap).
Moving averages are powerful TA indicators and one of the most common in use. The ability to analyze market trends based on data allows you to better understand how the market works. However, keep in mind that MA and crossover signals should not be used separately, and it is always safer to combine different TA indicators to avoid false signals.