Trading Strategies: Moving Averages
What are Moving Averages?
One of the most commonly used technical indicators, moving averages are simply a way to smooth out price fluctuations. The nature of the market which causes prices to go up and down may confuse or even fool an experienced trader. Moving averages assist in distinguishing between actual trend reversals or simply just market noise.
Moving averages are calculated by taking the average closing price over an X period of time. Plotted on a chart, it would like something like this:
Like every indicator, moving averages is used to help forecast future prices. Some traders can better determine the potential direction of the market by looking at the slope of the moving averages. Some others use moving averages as support or resistance levels. And some look for moving averages crossover. No one strategy is a guaranteed money maker – more strategies you know, the better your forecast will be. We will discuss more on this later.
Normally smoother the moving averages are less reactive it is to price movement. And of course the choppier the moving average, the more reactive it is to price movement. Also, moving averages with a longer time period generally have a smoother curve and more reliable (less prone to fake breakouts or fakeouts).
What Moving Average Time period should i be using?
The more commonly used time frames are 50,100, 200 period moving averages. Many traders also use 8,12,25 period and so on. But which ones should you be using?
Well the thing you need to note is that, the shorter the length of the time period, the less data points you are including to your moving average calculation. Which means the moving averages will be more sensitive to current prices. This has its pros and cons, more sensitive moving averages help identify a change in trend quicker but it also less reliable as fake outs are more likely to occur.
The opposite is true for longer length time period. Disclaimer – fake outs happen in for ALL indicators, just less common for longer time period indicators as more data points are included.
Using just either one by themselves can make it difficult to forecast prices. Hence you will soon notice that most traders use a combination of both short and long moving average time periods.
Simple vs Exponential Moving Averages
We are not going to bore you with how Simple Moving Averages (SMA) or Exponential Moving Averages (EMA) are being calculated. Please google that if you would like to know.
However we will explain to you the pros and cons of each. Let’s start with Simple Moving Averages (SMA). SMAs are less responsive to price action and thus have a smoother moving average curve. SMAs work well when looking at longer time frames as it gives u an idea of the overall trend.
One of the pros of being less responsive to price action is that SMAs produce less fake outs when compared to EMAs. The downside is that being less responsive to price action, you will probably miss out on getting in at a good price.
If you want a moving average that responds more quickly, then a shorter period EMA might suit your style better. EMAs can help indicate trends quicker, which can result in more profit. The earlier u can catch a trend, the longer you can ride the profits! The cons of this is of course you would be more prone to fakeouts especially consolidation periods (market moving up and down sideways).
Below is a table to help summarize:
Now the big question is.. WHICH IS BETTER?
This is entirely up to each individual trader. Some traders do better with shorter period moving averages and some prefer longer period moving averages. Most traders start off testing out both until they find their preferred weapon of choice.
Many experienced traders will plot both types of moving averages to give an idea of the full picture. The longer moving average is used to determine what the overall trend is, and the shorter moving average is used to find a good trade entry.
Our next article will discuss the different strategies moving averages can be used for. Stay tuned
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