Technical analysis is a study of past and present price charts in order to determine the likely direction of the stocks and other securities traded in the market.
Investors focus on fundamental ratios such as price to earnings, sales growth, earnings growth, economical data, price to sales ratio, supply and demand when trying to value the market.
On the other hand, technical traders analyse price action on charts along with other indicators to see what price levels the other market participants are buying and selling. Moving averages play a crucial role in this study.
In this article, we will discuss how moving averages are calculated, how technical analysts use moving averages for trading, moving average crossover and how it can help traders in buying and selling of securities. Before we start, let us know what the moving average is.
What is the moving average and how is it calculated ?
In simple terms, as the name suggests, moving average is the average price for a security over a set time period.
Moving averages are widely used as a trend indicator and to determine dynamic support and resistance levels. It’s a simple technical analysis tool in which the average is taken over a specific period of time, like 10, 20 or 50 days or any time period the market participant chooses. Let us understand how moving averages are calculated with a simple example.
Assume for a moment: 7 people are asked to drink cold beverages. Each one of them started drinking based on their capacity and willingness. Here is the list showing how these people end up drinking cold beverages;
| Person | No of Cold Beverages |
| 1 | 10 |
| 2 | 12 |
| 3 | 6 |
| 4 | 8 |
| 5 | 12 |
| 6 | 10 |
| Total Number Of Cold Beverages Consumed | 58 |
As an analyst you do not know how many bottles of cold beverages each one of them consumed. To know roughly how many bottles each one of them consumed, you can do a simple maths by dividing the total number of bottles consumed by the total number of people.
In our case, the total number of cold beverages consumed / total number of people = 58/6 = 9.667 bottles per head. That means 9.667 cold beverage bottles are consumed by one person.
Few of them consumed above and below the average, however our estimation without knowing the actual consumption is 9.667 per person.
Now, let us apply the same concept in order to arrive at a moving average price of a stock.
Let’s assume the closing price of stock XYZ over the past 5 days is 100, 120, 95, 105 and 110 rupees. In this case, the 5-period moving average of stock XYZ is [100+120+95+105+110] / 5 = 106.
This means, a five day simple moving average adds up the five most recent daily closing prices of the stock and divides it by 5 to create a 5-day moving average each day.
After finding the 5-day moving average price for each day, you connect these by creating the singular flowing line.
You are not required to do any manual maths to calculate moving averages, charting software does the calculation for you. In your charting software, you get a simple moving average as a smooth line on your chart indicating the average price of the stock for the selected period of time. Which is why it’s also known as simple moving average (SMA).
Extending this concept to stock, 200-day SMA is calculated by taking the closing stock price of 200 days of a particular stock and dividing it with 200. You can calculate moving average for any time period. The 200-day simple moving average is used when you want to analyse the long term trend of a stock.
Most popular moving averages used by traders
Most professional traders use moving averages to know the trend of the market in different time frames.Common moving average lengths used by traders are 5, 8, 9, 10, 20, 21, 34, 50, 100 and 200 periods.
50, 100 and 200 days SMA are beneficial to a long-term trader.
Whereas, 5, 8, 9, 10, 20 and 21 periods simple moving average benefit to a shorter-term trader.
The most popular moving average used by traders is the 20 period simple moving average. You will find it in most of the trader’s price charts along with candlestick charting or bar charts.
In addition to the 20 period moving average, traders also use 9, 34, 50, 100 and 200 period moving averages based on their trading strategy. 9 is generally interchanged by 5, 8 or 10 period simple moving averages depending on trader’s preference. Similarly, many traders prefer to use 21 SMA instead of using 20 SMA.
Moving average crossover
Moving average crossover is a method to enter and exit from a trade. When a shorter term moving average crosses over a longer term one, traders prefer to go long. They prefer to go short, when the shorter term simple moving average (SMA) crosses under the long term SMA.
You can test the performance of different short and long term moving averages that fit your own time frames. This system will decrease the number of trades that you may get purely based on moving averages.
Here are the best SMA combinations used by traders in moving average crossover system;
- 5/9 and 20/50 in daily chart
- 5/9/20 and 100/200 in intraday chart
Moving average crossover system is a trend following system that works in a trending market. In a tightly range bound or volatile market, moving average crossover will not give you a good entry and exit signal. Therefore, you must back test this idea to know how it works within your trading time frame.
One of the benefits of backtesting moving average crossover is that you can easily identify the upswings and downswings in the market. You can catch both sides for profits or can stay on one side in a trending market. You can be on the right side of a big trend when it occurs.
What moving average indicates in price charts?
Moving average is used to smooth out the price action of financial security. It focuses on where the current market price is trading in relation to the average price, over the trader’s time frame. In other words, the moving average is used to cut down the noise on a price chart. Direction of the moving average indicates which way the stock price is moving.
If the simple moving average (SMA) line is angled up, the stock price is moving up overall. Which means, when the price is above moving average, the trend is up. When the SMA line is angled down, the stock price is moving down overall. If the price is below moving average, the trend is down.
If the moving average moves horizontally for an extended period of time, then the stock price is likely in a range and the direction is sideways.
In an uptrend market, moving average can be considered as a support level. In a downtrend market, it acts as resistance.
When price crosses above or below the moving average, it signals a potential change in trend, which is also known as crossover.
When the stock price crosses above a moving average, it indicates a buy signal, and when the price crosses below the moving average, it can be used as a sell signal.
As discussed above in the moving average crossover section, if you draw two simple moving averages (SMA), one longer and one shorter, then the crossover indicates either buy or sell signal.
When the shorter-term SMA crosses the longer-term SMA, it indicates buy, known as the golden cross. When the shorter-term moving average crosses below the longer-term, it’s a sell signal, known as death/dead cross.
This means, if you plot a 200-day and a 50-day moving average on your chart, a buy signal occurs when the 50-days SMA (shorter-term) crosses above the 200-days (longer-term). When the 50-days SMA drops below the 200-day SMA, a sell signal occurs.
Simple Vs Exponential Moving Average (EMA) – Which is better?
One of the basic assumptions of technical analysis is “market discount everything”. Therefore, the latest stock price discounts all the known and unknown information. Based on the latest stock price, weightage are assigned to each recent closing price to calculate exponential moving average (EMA).
This means, an exponential moving average gives greater importance or weight to recent prices, to make it more reactive and faster to adjust to price action as the security trade.
You no need to know how to calculate EMA or what weightage to be assigned to latest closing stock prices. Charting software will do it for you.
In comparison to a simple moving average, an EMA changes faster due to assignment of weight. It gives traders faster entry and exit signals than a SMA.
What time frames can moving average be used on?
Moving average can be used on all time frames such as daily, weekly, monthly, 1 hour, 30 minutes, 15 minutes, 5 minutes and in any other intraday time frames you like.
For trend identification traders prefer to use moving averages on a higher time frame as they can see how the market reacts on a bigger time frame. In an uptrend, prices try to stay above the moving averages. In a downtrend, prices try to stay below the moving average.
Few specific moving averages such as 9, 20/21 and 200 SMA are used because they are used by so many other market participants.
No indicator is perfect, nor does it work everytime. Therefore, no single technical indicator will punch your ticket to market riches. Applying similar logic, you should not assume that moving averages are the Holy Grail of trading. They are technical tools to help you capture a trend in your trading time frame.
Moving averages are not considered as a great technical tool for a tightly range bound market. They are used primarily for trading trends.
You should decide how to incorporate moving averages into your own system and time frame.
Many technical analysts use moving averages in addition to other technical indicators and candlestick charts. We also have traders who prefer to trade naked, meaning without using any indicator on their price chart. It depends how a trader wants to trade in the market.
For confirmation, in addition to moving averages market participants also look at the following price patterns and technical indicators;
- Price action pattern formation such as Triangle, Head and Shoulder, Double top and double bottom, Bull and bear flag, and channels
- Support and resistance
- Trend lines
- Candlestick Patterns
- Moving Average Convergence Divergence (MACD)
- Relative Strength Index (RSI)
- Bollinger Band
- Stochastics
- Volume
- Pivots
- ADX
- Awesome Oscillator
- 3-10 Oscillator
Like any other technical indicators, moving average is considered as a lagging indicator. Therefore, most professional traders consider price action as supreme.
To understand price action you have to read and understand candlestick patterns formation and their interpretation within the market context. Here is a list of most important candlestick patterns for your further studies;
- Evening Star
- Morning Star
- Bearish Abandoned baby candlestick pattern
- Bullish Abandoned baby candlestick pattern
- Three Inside up/down
- Three outside up/down
- Inside Bar
- Bullish Piercing
- Dark Cloud Cover
- Spinning Top
- Shooting Star and Inverted Hammer
- Hammer & Hanging Man
- Gravestone, Dragonfly and long-legged Doji
- Engulfing Candlestick Pattern
- Marubozu candlestick pattern
Be sure you practice identifying and trading these candlestick patterns on a demo account before trading them with real money.
Disclaimer: In addition to the disclaimer below, please note, this article is not intended to provide investing or trading advice. Trading in the stock market and in other securities entails varying degrees of risk, and can result in loss of capital. Most investors and traders lose money. Readers seeking to engage in trading and/or investing should seek out extensive education on the topic and help of professionals.
