A moving average is a line on a chart that smooths out the price data. There are two main types of moving average: the simple moving average (SMA), which takes the arithmetic mean of a given set of prices over a specified number of periods in the past and the exponential moving average (EMA), which is a weighted average that gives more importance to the price in more recent periods, thus making it more responsive to new data.
As any other indicator it lags since it’s based on past price data. So, the longer the period, like for example the famous 200-day moving average, the greater the lag. You can choose whatever time frame you prefer; however the most used moving averages are the 50, the 100 and the 200 days moving average.
50 Day SMA (Blue), 100 Day SMA (Yellow) and 200 Day SMA (Red)
Moving averages are usually used to identify the trend direction of an asset or to determine its support and resistance levels. To identify the trend direction, traders look at where the short period moving average is compared to the long period moving average.
If the short period moving average is below the long period one, then it’s a downtrend. If the short period moving average is above the long term one, then it’s an uptrend. Traders also like to see all the moving averages first to cross to one side or another to confirm the trend and avoid false signals.
Moving Averages signalling trend changes
The most famous crosses are “the golden cross” and “the death cross”. The golden cross is when the 50-day moving average crosses the 200-day moving average to the upside confirming an uptrend. The death cross is when the 50.day moving average crosses the 200-day moving average to the downside signalling a downtrend.
The Golden Cross and the Death Cross
The other way of using the moving average is as a dynamic support or resistance. The price rarely goes in a straight line, in fact there are usually pullbacks during a trend following the normal ebb and flow of the market.
These pullbacks can bounce from the moving averages, and a trader can structure entries from those same moving averages in anticipation of a continuation of the previous trend and limit the risk by placing stop losses some distance behind them. Below you can see how the 50-day and 100-day moving average acted as support for the S&P500.
50-day and 100-day moving averages acting as support
Don’t use moving averages on their own for your trading decisions but always have a fundamental view first for direction and then a technical structure if you need it for entries and exits.
This article was written by Giuseppe Dellamotta.