Simplicity, transparency, and ease of use are just a few reasons why moving averages are among the most popular and widely used technical indicators on the market today. They come standard in every available charting package and trading platform, and plenty of traders—including the world’s best and most experienced—rely exclusively on a combination of pure price action trading and moving averages to plan and execute trades across every market, asset, and time frame.
So perhaps needless to say, a solid working knowledge about moving averages and how best to use them within your particular trading strategy is an absolute must. And that’s why we wanted to take this time today to discuss moving averages beginning with the basics, things like what moving averages are, how to derive meaningful trade signals from them, and what to do (and not do) when using moving averages in your trading.
What Do Moving Averages Signify, Anyway?
By definition, moving averages, or MAs, represent a running average of data from a given set of values, like price over the last 10, 20, 50, or 200 days, for example. Moving averages are used by traders, statisticians, and others, to smooth out regular fluctuations and better analyse prevailing trends, and are deemed “moving” averages because as more recent values are taken into consideration, an equal number of older values are removed from the calculation set.
Moving averages are commonly used by traders to identify and confirm uptrends or downtrends, spot changes in momentum, and even signal potential trading opportunities, all subjects we’ll cover in more detail later on. First, however, let’s examine the two main types of moving averages:
- Simple Moving Averages (SMAs): Calculated just by taking the arithmetic mean of the last “x” number of values. For example, the last 10 closing prices for a given asset or currency pair, in the case of a 10-day SMA.
- Exponential Moving Averages (EMAs): Exponential, or “weighted” moving averages use a rather complex calculation to give a higher degree of importance to more recent data, like the 5 most recent prices when calculating a 10-day EMA, for example. Fortunately, most any charting package and broker platform will measure and chart EMAs for you, so it’s not really necessary to study the formula, which you can see here.
There’s plenty of debate across the trading community about whether EMAs are better indicators than SMAs, but this, like many things in trading, is a decision best left to each individual trader.
Another key decision is how many periods to track using MAs, and whether to use minutes, hours, days, or other measures as your go-to period, and there is some specific guidance to consider in doing this. Long-term traders will want to look at longer-term moving averages, obviously bypassing hourly measures in favour of say, the 20-, 50-, and 200-day MAs. And conversely, intraday traders will examine shorter time frames, and likely use minutes or hours as the basis for their moving averages.
Our advice would probably be to start with 20-, 50-, and 200 periods, and feel free to experiment with others—by demo trading with them, of course—to see if other parameters are more preferable for you and your style of trading.
3 Ways to Use Moving Averages in Your Trading
Moving averages are considered lagging indicators as opposed to leading ones, so while they aren’t intended for predicting future movements, they’re useful nonetheless for providing traders a clearer picture of the trading landscape, and perhaps imparting some helpful confirmation as they plan and execute trades.
Let’s be clear about one thing in particular, though, before we examine how best to use moving averages in your trading. It’s important to realise that MAs are merely technical indicators that alone do not provide actionable trade signals. When incorporated as part of your analysis process and trading strategy, however, you’ll likely find that moving averages are helpful measures that can be used quickly and effectively without “clouding” your analysis or imparting too much extraneous information.
Here’s how we might recommend longer-term traders use moving averages to support their trading:
- To analyse trends & trend reversals: An upward-sloping moving average line is used, in part, to confirm an uptrend in the asset or currency pair being tracked, while a downtrend is confirmed by a downward-sloping moving average line. Moving averages cannot be used to identify actual reversal points in advance, however, as they are, again, lagging indicators.
- To gauge momentum: Strong and decisive momentum is said to be present whenever the order, angle, and separation of a series of moving averages, like the 20-, 50-, and 200-day MAs, for example, is noticeable on a chart. In other words, to help confirm an uptrend has momentum working in its favour, the 20-day MA line would be above the 50, which itself would be above the 200 (see below example in USDSEK). The reverse would be true in the case of a downtrend with sustained momentum.
- As potential chart support or resistance: Moving average lines on the charts are also considered strong support and resistance under the terms of the Lazy Trader methodology. With that, we are inclined to trade our go-to chart pattern, the pin bar reversal, whenever such a pattern prints with price approaching a moving average line.
To learn more about trading with moving averages, become a member of The Lazy Trader community, as your subscription includes weekly market analysis videos and timely trade ideas. There, you’ll see for yourself how SMAs and EMAs factor into our trade decisions and develop more confidence in your own trading as well. Click the banner below to activate your no-risk trial today!
Latest posts by Rob Colville (see all)
- Trade with The Lazy Trader in 2017! - November 18, 2016
- Round the Clock Trader Live – How to Trade the News - November 8, 2016
- Why There’s Little Room for Expectations in Trading (or in Life) - October 14, 2016