Moving Average Based Indicators
The Moving Average is one of the most widely used technical indicators because it is versatile and it is simple to set up and use. Basically, it is a device used to follow and detect trends in the movement of a financial product. The technical analyst will use it to identify the formation of a new trend or to signal when an old trend has ended or has reversed.
The theory behind the Moving Average indicator is that it is easier to detect trends because it acts to smooth out the short term volatility inherent in the price action of the financial product and thus makes the trend identification much clearer. When a technical analyst overlaps the price action with its moving average, buy and sell signals can be generated. It is important to mention that these signals will have a lag to the market conditions, therefore a Moving Average is a trend following indicator.
A trader can choose how many periods (measured in minutes, hours, days weeks, etc..) are to be incorporated in the calculation of the moving average. In the the above example, the blue line represents a simple 21 day moving average (The period is 21 and is measured in days) which is calculated by adding the previous 21 day's closing prices together and dividing by 21 to arrive at the average. The average is ´moving´ because the calculation is interested in the last 21 days worth of data - At the beginning of a new trading day the 21 day moving average is recomputed by discarding the oldest day from the previous calculation and adding yesterday's new data in its place. Therefore, the moving average is constantly updating itself.
Variations of Moving Averages
There are some criticisms of using the Simple Moving Average. The argument is that the most recent day's data is not given enough weight in the calculation. Some analysts like to assign a higher level of weighting to the more recent data. The Simple Moving Average gives the same weighting to each of the last 21 day's data. In order to rectify these concerns some analysts use a Linear Weighted Moving Average, represented by the pink line in the chart above. Here the 21st day´s data (the most recent) is multiplied by 21, the 20th day´s data by 20, the 19th day´s by 19 and so on, making the moving average more reactive to recent changes.
A further criticism of the moving average is that it does not include all of the data in the life of the financial product. The solution to this is the Exponentially Smoothed Moving Average, which takes into account all of the past data. The exponential moving average hugs the actual price more closely than the Simple Moving Average.
Which Moving Average should a trader use?
The Exponential Moving Average is more sensitive and better for shorter time periods as it can alert to changes quicker. However, the trade off is between sensitivity and reliability. Since the exponential calculation responds quicker to short term movements, they may also be prone to giving false signals. Simple Moving Averages work well for longer-term situations that do not require a lot of sensitivity.
Trend Identification
As this is a trend following analysis tool, any signals generated from the moving average indicator work well when the financial product develops a strong trend. Contrary to this, the moving average is ineffective when the price is in a trading range. Therefore, the moving average is used for trend identification and following and not for trend predicting.
How to use Moving Averages
There are some basic techniques a trader can employ to identify whether the price movement of a financial product is in an upward trend or a downward trend, examples of these are shown in the chart below:
A) A trader can simply examine the direction of the moving average for significant upturns or downturns. Therefore at Point A the moving average is heading downwards and so signals a down trend.
B) A second technique is to use the price location. If the price is located below the moving average then there is a downward trend in place, point B, and visa versa for the price being located above the moving average.
C) When the price crosses and moves above the moving average, a buy signal is generated, point C. A sell signal would be generated if the price crosses and moves below the moving average.
D) The more conservative analysts like to see the actual moving average line turn in the direction of the crossing before committing, point D.
Versatility
One of the main advantages of the Moving Average indicator is its versatility. There are many variables used in the calculation, timeframe (mins, hours, days, weeks), how many periods and which type of price to select (closing price, midpoint price etc..). Therefore, traders can make use of this tool for short, mid and long term positions. Through experience a trader can taylor the calculation so that it suits their trading style and provides the best chance of triggering profitable trading signals.
Double Crossover method
Another method that is used by technical analysts is to use two moving averages on the same chart with different time periods. For example the chart could show the price of the financial product together with a 10 day moving average and a 50 day moving average. A trader can then compare the short term and long term moving averages with the price action. An example of this can be seen for the E-mini S&P 500 in the chart below.
The double cross over method can be used when two different moving averages are employed. When the short term moving average crosses the long term moving average to the downside then a sell signal would be triggered and visa versa. This method reduces the number of false signals generated but it has the disadvantage of lagging the market.
A moving average line can also create support and resistance areas for the price action shown above as the 10 day moving average provided a support level during the rally.
Moving Average Envelope
This technique adds an extra feature to the Moving Average techniques described above. It introduces a band either side of the moving average line to signify overbought and over sold levels. The envelope lines are parallel to the central moving average line and are positioned at a certain percentage away.
MACD (Moving Average Convergence Divergence)
This technique charts the convergence and divergence of short term and long term moving averages. MACD can create a graphical indicator of when short term movement of price is faster than the longer moving average would suggest. For example, during an uptrend the shorter moving average is rising faster than the longer moving average, creating a bigger gap between them.
Signals are generated when the MACD lines cross to create a buy or sell opportunity.
Conclusion
Moving Averages are some of the most heavily used technical indicators because it is a simple device that can be customised to suit the individual's preferences. It is important to remember that it is a lagging indicator that should promote trading with the trend. The problem with this device is that it is not effective in a ranging market and therefore should be used in conjunction with other technical analysis techniques such as the Relative Strength Index indicator which will be explained later.