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Last updated on May 29th, 2024
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Cate Cook

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Cate Cook
Cate is a journalist by profession who started trading shares in 2008, after which she became a full time CFD day trader for more than 10 years. She now combines her passions for writing and trading at MarketMates. Join the blog to receive the latest articles from Cate.
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Sam Eder

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Sam Eder
Sam is the Cofounder and CEO of MarketMates. He has traded since 2008 and is the Author of the Amazon best-seller The Consistent Trader. Over 42,000 traders have taken his Advanced Forex Course for Smart Traders. Join the blog to get his latest articles.
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How to Use Moving Averages: Guide for Traders

Unlocking the power of moving averages to give your CFD and forex trading an edge

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Moving averages are a fundamental technical analysis tool used by traders to smooth out price data by creating a constantly updated average price.

They are called ‘moving’ because they provide the latest average price, while also accounting for past data points, making them dynamic indicators.

They are used extensively by CFD and forex traders world-wide to help with their trading decisions.

In this lesson, I’m going to explain what moving averages are, and how to use them to give your trading an edge.

Unlocking the power of moving averages

Moving averages (MAs) are a widely used chart indicator that can help traders:

  • identify trends
  • assess the direction of price movement
  • filter out short-term ‘noise’ in the market
  • set stop-loss levels

(When we talk about noise, we mean price action that is not relevant to the main price trend, which may serve as a distraction.)

A moving average shows the trader the average price of that asset over a specified period of time.

For example, a five-day simple moving average (SMA) adds up the five most recent daily closing prices, and then divides this figure by five to create a new average each day. Each average is connected to the next one, creating a single connected line.

Naturally, the average price will change according to the time period chosen.

By using more than one moving average, calculated using different time periods, new information emerges which is of great interest to traders.

Many traders use moving average crossovers – that is, when one moving average line crosses over another – as a trade entry or exit signal.

What do moving average indicators look like?

A moving average (MA) price indicator is displayed as a single line on a trading chart, usually in a colour that will help it stand out from the background candlesticks.

In all charting programs, it is possible to specify over what time period the average is displayed.

The following example shows a chart with a simple five-day moving average plotted over price action candlesticks.

 

Simple moving average line

 

Different MA lengths (e.g a 5-day MA, or a 90-day MA) show varying sensitivity to short-term price action.

It makes sense that the shorter the time period used for the moving average indicator, the closer the line will be to immediate price action.

Longer term moving averages are less sensitive, but reveal information about trends that short-term moving averages won’t reveal.

It’s possible to have several moving average lines displayed on a chart at the same time.

Quite often, when different moving average lines cross over each other, this may signal a trade entry for those traders using moving averages to determine their entry point.

How to use moving averages to identify trends

One of the primary uses of moving averages is to identify trends in the market.

By plotting moving averages on a price chart, traders can visually assess whether an asset is trending upwards, downwards, or moving sideways.

Market Wizard Marty Schartz said:

“The 10-day exponential moving average (EMA) is my favourite indicator to determine the major trend. I call this ‘red light, green light’ because it is imperative in trading to remain on the correct side of a moving average to give yourself the best probability of success.

When you are trading above the 10-day, you have the green light, the market is in positive mode and you should be thinking buy.

Conversely, trading below the average is a red light. The market is in a negative mode and you should be thinking sell.”

Using MAs to assess the direction of price movement

When I was day trading stock CFDs, I used a five-day moving average and a 20-day moving average on my charts.

These were my trade entry signals:

  • when the five-day MA crosses over the 20-day MA from below, it’s known as a ‘golden crossover,’ and signals entry for a long trade.
  • when the five-day MA crosses over the 20-day MA from above, it’s known as a ‘graveyard crossover,’ and it signals the entry point for a short trade.

I found moving averages to be a very reliable indicator of the direction of price movement, and so gave great trade entry signals.

This is the first entry signal I taught beginner traders, because it is very easy to spot, and is a reliable indicator.

However, an indicator on a chart should never be used as the sole determinant for a trade entry.

If you’d like to know more details about entry strategies, this is covered in the Advanced Forex Course for Smart Traders

The following example shows a golden crossover, with the five-day MA crossing over the 20-day MA from below.

Golden crossover

The grey line closely following price action is the 5-day MA, whereas the red line which smooths out price action is the 20-day MA.

This next diagram shows a graveyard crossover, with the five-day MA crossing over the 20-day MA from above.

Graveyard crossover

Notice how the golden crossover is at the beginning of an uptrend, and the graveyard crossover appears at the beginning of a downtrend?

Using MAs to filter out short-term ‘noise’ in the market

Different types of moving averages

In addition to a simple moving average (SMA), there are also two other types of moving average:

  • Weighted Moving Average (WMA)
  • Exponential Moving Average (EMA)

Weighted Moving Average (WMA)

A Weighted Moving Average (WMA) smooths out price fluctuations in a chart by assigning different weights to past data points using a mathematical model called linear weighting.

Unlike a simple moving average (SMA) that gives equal weight to each data point in the specified period, a WMA gives more weight to recent data points, and less weight to older data points.

This allows the WMA to react more quickly to recent price changes compared to a SMA.

Exponential Moving Average (EMA)

An Exponential Moving Average is also a type of moving average that assigns more weight to the most recent prices in the calculation.

However, the way it assigns this weight is different to a WMA, and is not linear.

The exponential moving average gives more weight to recent prices, making it more responsive to current price changes compared to the WMA.

This responsiveness can help traders identify trends more quickly and react accordingly.

EMAs are often used to confirm trend direction and identify potential entry/exit points.

They are used for short to medium-term trend analysis, and are a popular choice for traders seeking timely signals for potential trend reversals.

Which moving average is the best one to use?

The best moving average to use will depend on various factors, including your objectives, trading style, and the market conditions.

Each type of moving average has its advantages and disadvantages.

Here are some examples of situations when one moving average may be better than another:

Simple Moving Average (SMA):

  • Trend confirmation: SMAs are effective for confirming the direction of a trend over a longer period. Traders looking for a reliable indication of the overall trend may prefer using SMAs.
  • Smoothed price action: In markets with less volatility, SMAs can provide smoother price action, reducing false signals and noise.

Exponential Moving Average (EMA):

  • Quick response to price changes: EMAs respond more quickly to recent price movements compared to SMAs. Traders in fast-moving markets or those looking for shorter-term signals may prefer EMAs.
  • Dynamic support and resistance: EMAs adapt faster to changes in price trends, making them suitable for identifying dynamic support and resistance levels in volatile markets.

Weighted Moving Average (WMA):

  • Recent data emphasis: WMAs assign more weight to recent price data, similar to EMAs. However, WMAs give even greater emphasis to the most recent prices, making them more responsive to short-term price movements.
  • Balanced response: While WMAs are more sensitive to recent price changes, they still consider historical data, providing a balanced view of price trends.
  • Precision in Trend Identification: Traders who prioritise precise trend identification and quick reaction to market changes may find WMAs more useful than SMAs.

Ultimately, the choice between using a SMA, EMAs or WMA, or a combination, depends on your preference, risk tolerance, and the specific characteristics of the market being traded.

Determining support and resistance levels

Moving averages can also act as dynamic support and resistance levels.

In an uptrend, the moving average may provide support, as prices pull back to the average before continuing higher.

Conversely, in a downtrend, the moving average may act as resistance, preventing prices from moving higher.

A 10-day MA acting as a support line:

10-day MA acting as support

A 12-day MA acting as a line of resistance:

12-day MA acting as resistance

Using MAs to set stop-loss points

Moving averages can also be used to manage risk, by setting stop-loss orders based on the distance between the current price and the moving average.

Traders may choose to exit a trade if the price closes above or below a certain moving average, thus limiting potential losses.

A versatile tool for the traders’ toolbox

Moving averages are a versatile tool that can assist traders in various aspects of their trading strategies.

Whether it’s identifying trends, determining support and resistance levels, generating trading signals, or managing risk, moving averages provide valuable insights into market dynamics.

By understanding how to use moving averages effectively, you can unlock their power to help you make more informed trading decisions and improve your trading performance.

Till next time,

Cate

Get this week's best trading content

Lessons for all levels of trader. Nail the basics, master your mindset and learn advanced techniques.

Cate Cook

Cate Cook

Cate is a journalist by profession who started trading shares in 2008, after which she became a fulltime CFD day trader for more than 10 years. She now combines her passions for writing and trading at MarketMates. Join the blog to get the latest articles from Cate.
Cate Cook

Cate Cook

Cate is a journalist by profession who started trading shares in 2008, after which she became a fulltime CFD day trader for more than 10 years. She now combines her passions for writing and trading at MarketMates. Join the blog to get the latest articles from Cate.

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© 2024 – MarketMates.
All rights reserved | Privacy Policy | Risk Disclosure

General Advice Warning: From time to time, you may receive general non-binding advice from us. This information is intended to be general and is not personal financial product advice. It does not take into account your objectives, financial situation, or needs. Before acting on any information, you should consider the appropriateness of the information provided and the nature of the relevant financial product having regard to your objectives, financial situation, and needs. MarketMates is not liable for or held responsible for any loss, financial or otherwise in relation to information received from MarketMates.

© 2024 – MarketMates.
All rights reserved | Privacy Policy | Risk Disclosure

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