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Moving Averages

Moving averages (MAs) are widely used technical analysis tools that help visualize trends and potential support/resistance zones. They are calculated by averaging a security's price over a specific period.


Understanding Trends:

  • Smoothing Price Action: By filtering out short-term price fluctuations, moving averages smoothen the price chart, making it easier to identify the underlying trend direction.

  • Upward vs. Downward Slopes: An upward-sloping moving average suggests an uptrend, while a downward slope indicates a downtrend.


Lagging Indicator:

It's important to remember that moving averages are considered lagging indicators. This means they react to past price movements rather than predicting future trends. The price often moves first, and then the moving average adjusts to reflect that movement.


Support and Resistance:

Moving averages can also act as dynamic support and resistance levels. During an uptrend, the moving average can provide support for the price as buyers might use it as a reference point to enter or re-enter positions. Conversely, in a downtrend, the moving average might act as resistance, potentially hindering price increases as sellers might use it as an opportunity to exit positions.


Here, the downward-sloping moving average aligns with the downtrend and potentially acts as resistance, capping price increases.



The moving average indicator reduces noise by smoothing out price and volume changes that might cause confusion in interpretation, making it easier to see the underlying trend. It appears as a line on a chart near price activity, indicating the average value of a security's price over a given period of time. To construct a 20-day moving average, sum up the closing prices over the last 20 days and divide by 20.


We repeat the calculation with each new trading day. Each time, only the prices from the previous 21 days are used in the calculation. This is why it's called a moving average.


There are other types of moving average as well, such as the exponential and the weighted moving averages.


While SMAs are popular, they have a drawback. Since they assign equal weight to all prices within the chosen period, they can sometimes give less importance to recent price movements. This can be an issue in fast-moving markets where recent prices carry more significance.


To address this limitation, technical analysts use the weighted moving average (WMA). The WMA assigns greater weight to more recent prices within the chosen timeframe, and less weight to prices further in the past. This allows the WMA to be more responsive to changing market conditions.


In simpler terms: Imagine a 21-day SMA. Each day's price has the same influence on the average. A WMA, however, is like a weighted seesaw, where recent prices sit closer to the fulcrum, exerting more influence on the average compared to older prices on the other side.


For example, to calculate a 5 day WMA, we should take the closing price of the 5th day and multiply this by 5, the 4th day by 4, the 3rd day by 3, the 2nd day by 2 and the 1st day by 1. Once the total has been determined, we then divide the number by the addition of the multipliers. If you add the multipliers of the 5 day WMA example, the number is 15.


While the WMA is a good improvement, it still only considers prices within the chosen moving average period. The exponential moving average (EMA) takes things a step further. It incorporates all past price data, but it assigns exponentially more weight to the most recent prices. This means the EMA reacts even faster to recent price movements than the WMA, while still considering historical price action.


Think of it this way: Imagine the WMA as a seesaw where recent prices get a little more weight. The EMA is like a constantly tilting seesaw, always giving the most weight to the newest price and gradually decreasing the weight for older prices as you go back in history.



The amount of time periods employed to calculate a moving average is an important factor. The length of a moving average should correspond to the market cycle you desire to track.

TREND

MOVING AVERAGE LENGTH

Short Term

20periods

Medium Term

50

Long Term

200

Do not use in a range. Moving averages perform better when the market is trending. In a range, this indicator is ineffective, and buy or sell recommendations will not operate.


How to Trade with the Moving Average?

Moving averages (MAs) are often displayed alongside price action on charts. Their interaction can sometimes provide clues about potential changes in the trend.


Price Crossovers and the Moving Average:

  • Breakout Above: If the price decisively breaks above the moving average, it can be interpreted by some analysts as a possible signal of upward momentum.

  • Breakout Below: Conversely, a price breaking below the moving average might be seen as a sign of downward pressure.


Confirmation Through Moving Average Direction:

The strength of these signals can be enhanced if the moving average itself begins to slope in the direction of the breakout. For example, if the price breaks above the moving average and the moving average starts to angle upwards, it might add some confidence to the idea of a potential uptrend.


Moving averages (MAs) can be used by some traders to identify possible entry and exit points for positions. Here's a breakdown of some common techniques:


  • Single Moving Average: This basic approach uses a single moving average. A price move above the moving average might be seen as a potential buying opportunity, while a move below the moving average could be interpreted as a potential selling opportunity.


  • Multiple Moving Averages (Crossovers):

    • Double Crossover: This method involves two moving averages with different lengths. If the shorter-term moving average crosses above the longer-term moving average, it might be viewed as a bullish signal (potential buy). Conversely, if the shorter-term moving average falls below the longer-term moving average, it could be seen as a bearish signal (potential sell).

    • Triple Crossover: This technique utilizes three moving averages. The interpretations of crossovers are similar to the double crossover method, but with the added complexity of a third moving average.


The Trade-Off: Fewer Signals vs. Confirmation:

While using multiple moving averages can potentially reduce the number of misleading signals (whipsaws), it can also lead to fewer overall signals. Traders need to weigh the pros and cons based on their trading style and risk tolerance.


Simple Technique

The chart below shows that prices are in a downturn. The ideal trade opportunity would be when prices are also below the moving average, indicating a significant downturn. We would sell when the price bounces off or crosses above the moving average and closes below it.


Buy and sell signals are given when the price crosses the moving average, the moving average changes direction, or the moving averages cross each other.


The Double Crossover Technique

The double crossover method is a technical analysis technique that utilizes two moving averages (MAs) with different lengths to potentially identify changes in trends.


The Mechanics:

  • Two MAs: This method involves using two moving averages, typically a shorter-term moving average (SMA-50) and a longer-term moving average (SMA-200). The choice of specific periods (50 and 200 days in this example) can vary depending on the trader's preference and timeframe.

  • Crossover Signals:

    • Buy Signal: A potential bullish signal (upward trend) might be generated when the shorter-term moving average crosses above the longer-term moving average.

    • Sell Signal: Conversely, a potential bearish signal (downward trend) might be indicated when the shorter-term moving average crosses below the longer-term moving average.



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