There are many uses for moving averages, but three basic uses stand out:
• Trend identifi cation/confi rmation
• Support and resistance level identifi cation/confi rmation
• Trading systems
Trend identification/ Confirmation
Moving averages are helpful in keeping you in line with the price trend by providing buy signals shortly after the market bottoms out and sell signals shortly after it tops, rather than trying to catch the exact bottom or top. There are three ways to identify the trend with moving averages: direction, location and crossovers.
The first trend identification technique uses the direction of the moving average to determine the trend. The trend is considered up when moving average is continuously rising. If the moving average is declining, the trend is considered down. The direction of a moving average can be determined simply by looking at a plot of the moving average or by applying an indicator to the moving average. In either case, we would not want to act on every subtle change, but rather look at general directional movement and changes.
The second technique for trend identification is price location. The basic trend can be determined through location of the price relative to the moving average. If the price is located below the moving average then there is a downward trend in place and visa versa for the price being located above the moving average.
The third technique for trend identification is the location of the shorter moving average relative to the longer moving average. The trend will go up is going up if the shorter moving average is above the longer moving average. If the shorter moving average is below the longer moving average, the trend is considered down.
Moving averages – key points
The Moving Average (MA) is the simplest and most widely used technical analysis tool. The
MA attempts to tone down the fl uctuations of market prices to a smoothed trend, so that
distortions are reduced to a minimum. MAs help in tracking trends and signaling reversals.
The most important merit of moving average system is that you will always be on “right” side
of the market.
Interpretation
Signals to buy or sell are generated when the price crosses the MA or when one MA crosses another, in the case of multiple MAs. Buy when prices move above the moving average line on the chart and sell when prices drop below the moving average line Another method used by technical analysts is using the two moving averages on the same chart with different time periods. Since the MA is a lagging indicator, a crossover will usually signal a trend reversal well after a new trend has begun and is used largely for confirmation. Generally speaking, the longer the time span covered by an MA, the greater the significance of a crossover signal. For example, the crossover of a 100 or 200-day MA is significantly more important then the crossover of a 20-day MA.
Moving averages differ according to the weight assigned to the most recent data. Simple moving averages apply equal weight to all prices. More weight is applied to recent prices in the case of exponential and weighted averages. Variable moving averages change the weighting based on the volatility of prices.
When prices fluctuate up and down in a broad sideways pattern for an extended period (trading-range market), longer term MAs are slow to react to reversals in trend, and when prices move sideways in a narrow range shorter term MAs often produce false signals. Flat and conflicting MAs generally indicate a trading-range market and one to avoid, unless there is pronounced rounding that suggests a possible new trend.
A variable moving average is an exponential moving average that automatically adjusts the smoothing percentage based on the volatility of the data series. Such moving average compensates for trading-range versus trending markets. This MA automatically adjusts the smoothing constant to adjust its sensitivity, often allowing it to outperform the other moving averages in these difficult markets.
Because of the potential for false signals MAs should always be used in conjunction with the other indicators. For example Bollinger bands adjust in distance from a moving average based on volatility, using standard deviation above and below the moving average rather than percentages.
Indicators which are especially well-suited for being used with moving averages include MACD, Price ROC, Momentum, and Stochastic. A moving average of another moving average is also common.