Moving averages represent highly effective technical analysis tools, although they are occasionally snubbed by purists of "hard" technical analysis, characterized by an intensive use of indicators and oscillators. Moving averages are effective because they take into account the most important data of all, namely the price, and they do so in a diachronic perspective, which gives the right importance to the time element.
In the following article, we will offer
an in-depth overview of moving averages, describing the many variations that can be used for technical analysis and providing some simple operational tips.
What are moving averages and what are they used for
First of all, it is good to answer the question:
what is a moving average? The concept of "average" is known to everyone, after all it represents an arithmetic element that is used in many daily activities. What makes the difference is the term "moving", which among other things reveals its importance from a technical analysis perspective.
The moving average is the average of the prices of the last sessions, however, detected in a dynamic way. That is, at each session the moving average is updated, integrating the most recent session into the calculation and removing the least recent session from the calculation itself. Each detection forms a point. The points, if joined,
form a curve. This curve is dynamic, in the eyes of the trader it seems to scroll, walk, change: it is the result, in fact, of the difference between one average and another, between one detection and another.
Moving averages, as already widely anticipated, represent a technical analysis tool, capable of providing operational signals and not only. The secret lies in
analyzing how the moving average interacts with other moving averages and, above all, with the price. We will talk about this dynamic in depth in the last paragraph.
In the next paragraph, however, we will address another topic, namely that of the types of moving averages. It is a propaedeutic topic, although sufficiently complex, necessary to understand how to best exploit the moving average tool.
The 4 types of moving averages
As already mentioned, there are various types of moving averages. The classification criteria are numerous, although three elements in particular are taken into consideration: speed, price type and weighting.
Fast and slow moving averages
Speed is one of the most important criteria when it comes to deciding which moving average to use. For the speed of the moving average, very trivially, we mean the number of sessions that are taken as a reference. If it is true that a moving average is the sequence of price averages recorded in a certain number of sessions, it is that "certain" that determines whether the moving average is slow or fast. Specifically,
a moving average that takes into account thirteen sessions or less is defined as fast; a moving average that takes into account more than thirteen sessions is slow.
The reason for this is intuitive, and concerns the sensitivity of moving averages to price changes. A moving average with few sessions on its shoulders is very sensitive to price changes, as the last detection weighs heavily. A moving average with many sessions, on the other hand, is less sensitive precisely because the last detection "almost gets lost" among the previous detections, which are numerous.
It is up to the trader to decide which moving average to use and, above all,
how many moving averages to use. It must be said, however, that fast moving averages are rarely used alone. Rather, they are excellent surrogates for the price line, especially when the market is so volatile as to pose difficulties in using the price line itself.
Moving Averages and price types
In general, in the calculation and representation of moving averages, the closing price of the session is always used. Yet, this is not an obvious choice. Also because, on closer inspection, there are various types of prices: opening, closing, minimum and maximum.
The
closing price is the one that, under more or less normal conditions, offers the best insights from a technical point of view. It also gives the moving average a marked readability. However, if conditions are not so normal, it is good to consider using other types of prices. For example, when intraday volatility is very high, the closing price may be unrepresentative of the real behavior of the market. The same goes for trading activities characterized by a very short time horizon, such as
day trading.
Simple Moving Average
It is the moving average par excellence, the one that is used most widely. It is also the easiest to build and interpret. On the other hand, given its "simplicity" it can give rise to false signals. For this reason it is rarely taken into consideration alone, therefore without the support of other moving averages. Similarly, it also reveals its fallibility in conditions of extreme volatility.
In any case,
the simple moving average is a curve formed by several points. Each point is calculated by adding the prices of the previous sessions and dividing the result by the number of sessions examined. In short, the simple moving average is nothing more than a set of arithmetic means.
In English, and therefore in technical jargon, the simple moving average is known as Simple Moving Average. It can be found with the acronym SMA.
Exponential Moving Average
The discussion is quite different for the exponential moving average. The calculation here is much more complex. Before presenting the formula it is good to clarify what the ratio is behind this type of moving average. The ratio is as follows: to give reactivity to the average, without thereby decreasing the number of sessions and, at the same time, its significance. To do this, the weighting tool is associated with the calculation. This weighting rewards the latest surveys compared to the previous ones.
That said, here is the formula.
EMA (i) = EMA (i-1) + SF * [P (i) – EMA (i-1)]
Where:
- EMA stands for Exponential Moving Average, which is the official name used to designate exponential moving averages.
- P (i) stands for the price in session (i), in most cases the "closing price".
- Ema (i) indicates the most recent value of the EMA
- Ema (i-1) indicates the previous value of the EMA
- SF is a smoothing factor, which is equal to 2/number of sessions + 1
Very complicated, right? No fear, the trader is not assigned any calculation. Today's platforms, in fact, automatically calculate moving averages. Therefore, it is sufficient to set a few parameters to see the exponential moving average appear on your chart.
Weighted Moving Average
The exponential moving average, in reality, is a subtype of weighted moving average. The weighting, in the case of the exponential, is much more complicated than it might seem and in any case favors the previous surveys.
In terms of weighting, the trader has a wide margin to customize the moving average. It is sufficient to assign a greater weight to a session or a group of sessions. The needs can be numerous, although the main one coincides with the need to compensate for periods of extreme volatility or, on the contrary, for extremely strong trends.
Triangular Moving Average
The
triangular moving average is also a weighted moving average. The purpose, however, is more specific here. That is to give more importance to the central values. Such a need could emerge, for example, when the market is in a condition of volatility or laterality, and the same condition has also involved the least recent sessions.
The weighting method, however, is quite unique in this case. Let's imagine an 11-period triangular moving average.
- Divide the number of periods by two, obtaining 5.5.
- Round the value just obtained up, obtaining 6.
- Calculate the simple moving average of the last 6 periods.
- Make an average of the average. Specifically, the 6-period moving average of the 6-period moving average obtained in the previous point.
In the event that the number of periods is even, rather than rounding it is sufficient to add 1.
Operating strategies
That said, how are moving averages used? There are numerous operational strategies, but in general two approaches are preferred. As you will discover shortly, they are seemingly very simple to execute. Indeed it is true, moving averages represent effective and accessible tools. The difficult part, as usual in these cases, lies in defending against false signals and deciding, above all, on the starting tools.
It is not so much the reading that gives problems, but the choice of the type of moving average, the number of sessions, etc. Therefore, pay attention especially to these points.
Moving averages as operational signals
In this case, moving averages can offer indications about the type of order, which can be long or short. Indeed, to put it better, the signals are offered by the interactions of the moving averages with the price line. Specifically:
If the price in upward movement crosses from the bottom to the top the moving average, it is good to take a long position.
If the price in downward movement crosses from the top to the bottom the moving average, it is good to take a short position.
Incidentally, the price can be replaced, in this analysis, by a very fast moving average. This should happen especially when the market is in a situation of extreme volatility.
This method could still give rise to false signals. To reduce the probability of false signals, it would be good to only consider closing prices, and completely ignore lows and highs.
Moving averages as dynamic levels
Moving averages can be used to produce
supports and resistances. The identification of supports and resistances represents one of the most arduous tasks for traders but, at the same time, more necessary. Moving averages allow the trader to cut to the chase, therefore not to engage in calculations and surveys regarding weekly, monthly lows and highs, etc.
In this case, it is "sufficient" to produce a long enough moving average and create a second curve by applying an addition or subtraction factor. Unfortunately, it is up to the trader to identify this factor. In most cases, it is preferable to use a convenient value plus a standard deviation. Among other things, it is the principle with which the Bollinger bands are created, which in fact is an indicator that makes extensive use of moving averages.
In addition, however, the Bollinger Bands have a central curve, which represents a simple moving average.
In any case, if moving averages are used as dynamic resistance and support, the reading of these levels would become quite simple. The curve above the price would indicate resistance, the curve below the price would indicate support.
