Whether you’re an experienced trader, or just starting out, understanding how to use moving averages to find the trend can give your trading a significant edge.
Traders use moving averages to smooth out price data, by creating a constantly updated average price.
People call them a ‘moving’ average because they provide the latest average price, whilst also accounting for past data points, making them dynamic or ‘moving’ indicators.
Forex and CFD traders use moving averages extensively to help determine trend direction, and to assist with their overall trading decisions.
In this lesson, I’m going to explain what moving averages are, and how to use moving averages to find the trend and so give your trading an edge.
What are moving averages?
A moving average is a technical indicator that calculates the average price of a security over a specific period of time.
There are three main types:
- Simple Moving Average (SMA)
- Weighted Moving Average (WMA)
- Exponential Moving Average (EMA)
Each has its own characteristics, and is used in different trading strategies.
Simple Moving Average (SMA)
The most straightforward of the three, an SMA calculates the average price of a security over a specified period.
Each data point is given equal weight. This means that older data points have the same influence on the average as more recent ones.
SMAs are often used to identify long-term trends, as they’re less sensitive to short-term price fluctuations.
Weighted Moving Average (WMA)
A WMA assigns greater weight to more recent data points, which makes it more responsive to recent price changes.
This is because it multiplies each data point by a weight, with more recent data points having higher weights.
WMAs are useful for traders who want to give more importance to recent price action.
Exponential Moving Average (EMA)
An EMA also places more emphasis on recent data points, but it does so in a more exponential manner.
This means that the weight assigned to each data point decreases exponentially as it gets older.
EMAs are generally more responsive to price changes than SMAs, making them a popular choice for short-term traders.
Using moving averages
Moving averages (MAs) are a widely used chart indicator that can help day traders:
- identify trends
- assess the direction of price movement
- filter out short-term ‘noise’ in the market
- set stop-loss orders
(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.
Connecting each average to the next one creates 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 trend information emerges which is of great use 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.
Trend indentification using moving averages
This is the basic way to use a moving average for trend identification:
Select a moving average:
The choice of moving average depends on your trading style and the market you’re analysing.
Shorter-term averages (like 5-day or 20-day) are often used to identify short-term trends, while longer-term averages will indicate broader market trends.
Plot the moving average
Add the chosen moving average to your chart. If you are using TradingView as your charting sortware, moving averages are found under the ‘indicators’ tab.
Interpret the trend:
- Uptrend: When the price is above the moving average, it generally suggests an uptrend.
- Downtrend: When the price is below the moving average, it generally indicates a downtrend.
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, you can specify the line colour, and over what time period the average is displayed.
The following example shows a chart where I’ve plotted a simple five-day moving average over price action candlesticks.
Different MA lengths (e.g a 5-day MA, or a 90-day MA) show varying sensitivity to short-term price action.
Therefore, 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.
You can display several moving average lines 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 trade entry point.
How to use moving averages to find the trend
One of the primary uses of moving averages is to identify trends in the market.
By plotting moving averages on a price chart, you 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.”
How to use moving averages for swing trading
When I was day trading stock CFDs, I used a five-day moving average and a 20-day moving average on my charts as a swing trade indicator.
These were my swing 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 me great swing trade entry signals.
This is also the first entry signal I teach 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 2.0.
Example of a golden crossover swing trade
The following example shows a golden crossover, with the five-day MA (grey line) crossing over and above the 20-day MA (red line) from below.
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.
A graveyard crossover swing trade
This next diagram shows a graveyard crossover, with the five-day MA crossing down over the 20-day MA from above.
Notice how the golden crossover is at the beginning of an uptrend, and the graveyard crossover appears at the beginning of a downtrend?
As soon as I noticed either a golden, or graveyard crossover, I took the crossover as a trade entry signal, either long (golden) or short (graveyard.)
Using an hourly chart, enter your trade as soon as the crossover is noticed, in the direction of the shorter moving average.
Which moving average is the best one to use?
The best moving average to use depends 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. Day traders looking for a reliable indication of the overall trend often 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 often use 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 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 serve 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:
A 12-day MA acting as a line of resistance:
Using MAs to set stop-loss points
Traders can use moving averages 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 and reducing risk.
A versatile tool for the traders’ toolbox
Moving averages are a versatile tool that traders can use for various purposes.
Whether it’s identifying trends, determining support and resistance levels, generating trading signals, or managing risk, moving averages provide valuable insights into market dynamics and price direction.
By understanding how to use moving averages effectively, you can gain a great deal of insight into price action.
They are a powerful tool to help you make more informed trading decisions, and so improve your trading performance.
If you are a beginner trader, I believe it’s well worth spending the time to explore the use of moving averages, and to become familiar with their use.
Till next time, happy and safe trading!
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Sources
Marketmates uses only high-quality sources, including peer-reviewed studies, to support the facts within our articles. Read our editorial guidelines to learn more about how we fact-check and keep our content accurate, reliable, and trustworthy.
- Louise Bedford – The Secret of Candlestick Charting https://www.tradinggame.com.au/product/technical-analysis/the-secret-of-candlestick-charting/
- Investopedia – What Is A Moving Average? https://www.investopedia.com/terms/m/movingaverage
