Moving Averages: Why We Use Them
I feel obligated to give an trader’s definition and just a few points about the basics concerning moving averages before getting personal and specific as to what we at Tradeview Markets use. Most of you are probably, at least familiar, or have heard of moving averages, so I will be brief. Few technical indicators are as popular and universally followed as the moving averages. Moving averages help us define a trend and also help recognize the changes in the trend. They do NOT predict price direction but rather define the current trend with a “lag” so to speak. Moving averages lag because they are based on past prices. One of the main functions of a moving average is to identify trends and trend reversals but keeping in mind that moving averages don’t predict new trends but really confirm a trend(s) once they have been established.
Just like most tools or indicators that are offered on charting platforms, we are looking for what happens next and like most when looking at our charts, we wish to identify a trend, momentum and support and resistance. Moving average strategies are popular and can be tailored to any time frame for any type of trader, both short and long-term.
There are two main types of moving averages, regardless of the time period, very similar but just calculated in a different manner. They are the simple moving average (SMA) and the exponential moving average (EMA). The only difference between these two is the sensitivity each one shows to data used in its calculation. The EMA gives a higher weighting to recent prices than the SMA does, while the SMA assigns equal weighting to all values. Just a note and opinion that the Simple (SMA) is the most common type of average used by technical analysts. Traders, myself included, use the Exponential (EMA) since the EMA places a higher weighting on recent data than on older data, they are more reactive to the latest price changes than the SMA’s are, which makes the EMA more timely.
A disadvantage that seems to be common when relying on moving averages really comes when dealing in short term trades/trading. Remember that moving averages are calculated based on historical data and do not predict price direction and therefore results can be random when in faster markets. If the price action becomes volatile then the prices are choppier which can signal multiple signals or failing trend reversals. When this happens just use another indicator or just remember that “the trend is your friend” if you must do something in those conditions.
In conclusion, using moving averages makes isolating trends easier. Exponential moving averages react quicker to price changes than a simple moving average. Moving averages with shorter look back period (50 days, for example) will also respond quicker to price changes than the average longer period (200 days). Moving average crossovers are a popular strategy for both entries and exits and also highlight areas of potential support and resistance. As a general guideline, if the price is above a moving average the trend is up and the same on the downside. I use the 50/100/200 moving averages with the 50 day being the only EMA (shortest time period), but what’s most important here is that, just like any platform and charting system you use, you must work on it to where you are comfortable and are able to trust the charts and averages- and that takes time and practice.