Understanding Moving Averages

Moving Averages are one of the simplest technical indicators around. Moving averages do not make predictions about future price movements but they rather they define the current price direction with a time lag. Even though Moving Averages lag, due to the fact that they are based on past data they are useful as they smooth price action and they also filter out noise. The two most popular types of Moving Average used for trading, are the Simple Moving Average and the Exponential moving average. Click on images to enlarge.

A simple moving average is simply the average price of a security over a specific number of periods. The majority of moving averages are based on closing prices, as the name suggests old data is dropped as new data comes along. Exponential moving averages aim to reduce the time lag experienced, by applying a greater weight to more recent data while giving less weight to older data. Also the longer the moving average used the greater the time lag their will be, a 10 day moving average will hug the price data much more closely than a 50 day moving average. As the longer moving average will be based on a far greater range of data points. 

Even though there are clear differences between how simple moving averages and exponential moving averages are calculated. Exponential moving averages will turn more quickly than simple moving averages but are also prone to give more false indications of new trends in price direction. While simple moving averages offer a truer picture for the entire time period in question and some have suggested this makes simple moving averages better if one wishes to identify support or resistance levels.

Different traders often decide to use different time frames when using Moving Averages as an indicator. Short term moving averages (5-20) tend to suit those who are interested in short term trading and short term trends. Chartists who wish to hold a position for the medium term will typically use 20-60 day moving averages. While long term investors will likely only use moving averages of greater than a 100 days. 

By using two moving averages a trader can generate crossover signals. One popular crossover signal used is called the double crossover. A trader using the double crossover method will typically use one relatively short term moving average with another longer term moving average. When the short term moving average crosses above the long term moving average, this is known as a Golden cross and is taken as a Buy signal. Conversely when the short term moving average crosses below the long term moving average this is taken to be a sell signal and is known as a dead cross. A more complicated three cross system can be used where again the movement of the shortest of the three moving averages crossing the over two is taken to determine buy and sell signals. 

Charts created using the Plus500 Platform.

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