Moving Average (Technical Analysis)

The Moving Average is one of the most used technical analysis indicators. An MA displays the average of price during the previous N trading periods. The average is a very popular TA tool, there are a lot of different types of moving averages with new ones are being invented every day.

Different types of moving averages

The most commonly used MA is the simple moving average. This MA shows the simple arithmetic average of the price for the last N trading periods. For example, a 20 day simple moving average will calculate the average price for the last 20 days by adding up the price for all 20 periods and then dividing the total by 20. The chart below shows the 20 Simple Moving Average applied to the GBP/USD Daily chart.

The second most used moving average is the exponential MA (EMA). The EMA places greater weight on the more recent market data. To calculate an exponential moving average, take the current bar’s price and multiply it by an EMA%. Add the result to yesterday's EMA multiplied by (1 - EMA%). The EMA% here is the weighting attached to the current bar’s value. For example, 50% would be used for a 3 period EMA, 10% for a 19 period exponential moving average etc 1). Here is that same GBP/USD Daily chart from above only this time we applied a 20 period exponential moving average instead of an SMA.

Another popular moving average is the Weighted Moving Average (WMA). Like the exponential moving average, the WMA also places greater weight to the more recent market data although it uses a different calculation then the EMA. To construct a 5 period WMA, first add in the sum of all the periods 1+2+3+4+5=15. The weighted values are calculated by multiplying the current bar’s price by 5/15. The previous bar is given a smaller weighting of 4/15 and so on. The weighted moving average is the sum of these 5 weighted values. 2) The chart below shows the same Sterling chart with a 20 period weighted moving average.

This average can be applied to the bar’s closing price (the most common usage), the open, the high or the low of the bar. Other MAs use the candle’s Median Price (high + low / 2), the Typical Price (high + low + close / 3) or the Weighted Close Price (high + low + close + close / 4). You can also apply the moving average to other technical analysis tools. For example, if the Stochastic Oscillator is too volatile you could apply a moving average to it to smooth out the variations. The MA also forms a part of many other widely used technical indicators like the MACD. The full name of the MACD is the Moving Average Convergence Divergence Indicator. The MACD uses two MAs, a fast and a slower moving average and basically measures the difference between the two.

Moving Average Trading Strategies

The Moving Average is one of the most widely used technical indicators. Thus it’s no wonder that there are literally thousands of moving average trading systems floating around the internet. Most of them however fit into one of several categories.

The Moving Average Crossover Systems

The moving average crossover is by far the most common use for the moving averages in trading systems. This is especially true for traders new to the forex market. The simplicity and the ease of use makes this trading strategy easy to implement by anyone, even by someone who has just started trading.

The MA crossover system uses two or more moving averages. The entry signal is relatively simple. A buy signal is triggered when the faster (or shorter) moving average goes above the slower (longer) MA. On the flip side, a short is signalled when the faster moving average goes below the slower MA. In the case of triple crossover moving average systems, 3 MAs are involved. To generate a buy, all MAs have to be aligned with the fastest MA on top.

Let’s use 50, 100 and 200 triple moving average crossover system as an example. Here, the 50 MA has to be above the 100 MA and at the same time the 100 moving average has to trade above the 200 MA. For a sell, all 3 MAs have to be arranged in the reverse order. Here, the 200 MA has to be on top, followed by the 100 period and the 50 period moving average. The chart below shows an example of the 50 and 200 SMA crossover on the EUR/USD Daily chart.

Common values for double moving average crossover systems include 10 and 21 EMA (exponential moving average), 10 and 20 SMA (simple moving average), 50 and 100 SMA and 50 and 200 SMA. For triple moving average crossovers, the most widely used variations are 10, 20, 50 EMA and 50, 100, 200 SMA. Besides these, there are plenty of other moving average crossover variations out there. As traders usually adjust these strategies based on the timeframes and the markets they trade, there is no shortage of these types of systems on the internet.

Advantages of Moving Average Crossover Systems

The main advantage of moving average crossover systems is their ease of use. All modern charting solutions offer the MA option and most offer several different types of MAs to choose from. Few clicks later and you have yourself a chart ready for trading a MA system. Closely tied to this is another plus of MA crossover strategies, their simplicity. The entry for a crossover system is very simple and straightforward, there is no guessing game here and no subjectivity. As soon as that faster moving average goes over the slower MA, you initiate a buy. This is another factor that draws in many new traders to this simple looking trading technique. The best trading environment for a moving average crossover system is a trending market. Almost all profits generated by this trading strategy will come from large one sided price movements.

Disadvantages of Moving Average Crossover Systems

The main disadvantage of moving average systems is their ineffectiveness during range / flat trading periods. During ranges, this system is one of the worst to trade. With no clear direction, the market can swing back and forth aimlessly. As moving averages are just an average of the price itself, if price trades without a clear direction the MAs will follow suit and constantly generate losing crossovers signals.

The next one is not really a disadvantage if you do your backtest right. Moving average crossover systems can give away the false impression of profitability. It is very easy to look back at the charts and notice a large winning trade. I would’ve entered my buy trade here when the 10 EMA crossed over the 50 EMA and exited next year with a 1,500 pips profit. I’m sold! But we fail to notice the five or ten 200 pip losses that came before that large win. This is another reason why you should do proper backtesting before you trade any strategy with real money.

Single Moving Average Systems

The single moving average trading systems only include one MA. There are several different variations of a single MA setup. The simplest setup involves going long once price either crosses or closes above the moving average. A short is initiated on a close / cross below the MA. While this is a very simple and easy to implement trading strategy, it tends to work only during significant market trends. During ranges, the whipsaws are more severe compared to the double or triple moving average crossover systems.

The second most common MA setup is using the moving average as a visual guide in trading and not taking any trades based off of it. This is a lot more complex and harder to implement then all the other MA systems that we discussed so far. The reason for this is the subjective nature of the setup. A trader will generally keep the MA of their choice on the charts for a long time, slowly learning all its intricacies. If you decide to try this approach, be ready to invest significant amount of time and effort. This approach is entirely subjective. You’ll need to learn how the moving average behaves during trending and ranging markets. In addition, you’ll need to find a way to figure out if the market is trending or ranging based on a single MA alone. While this setup requires a significant time investment, in the long run, like all subjective approaches, it will likely outperform an entirely mechanical trading strategy. The picture below shows the 55 Exponential Moving Average on a 1 Hour Euro chart.

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