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Moving Average in trading: all you need to know
Technical indicators in trading are important to perform your analysis and to obtain the best possible benefits. One of the basic ones that everyone should know is the Moving Average.
Learn all about the Moving Average indicator. We will tell you what it is, how you can apply it, what it is used for and some strategies to replicate.
What is the Moving Average in Trading?
A moving average is a continuously calculated value of the arithmetic mean of the price of an asset over a specific period of time.
In trading, a moving average is used as a technical indicator to analyze the price behavior of a financial asset. Its main purpose is to provide a clearer view of the overall price trend, eliminating day-to-day fluctuations and highlighting the predominant direction of the market.
In markets, asset values can experience sharp and volatile movements over short periods. The moving average helps smooth out these fluctuations, allowing traders to identify more solid and lasting trends.
This indicator is especially useful in cryptocurrency trading due to the high rates of volatility that characterize these markets.
How to calculate the moving average in trading?
To understand how to calculate the moving average in trading, it is essential to know the two main types of indicators used: the Simple Moving Average (SMA) and the Exponential Moving Average (EMA).
Simple Moving Average (SMA)
The SMA is the most basic type of moving average in trading. It is calculated by taking the arithmetic average of the closing prices of an asset over a specified period.
Example of SMA calculation For example, to calculate a 10-day SMA, you would add the closing prices of the last 10 days and divide the result by 10. To update the average, the oldest price is removed and the most recent price is added.
Exponential Moving Average (EMA)
The EMA is a more sophisticated type of moving average that gives more weight to the most recent prices. This is accomplished by applying an exponential smoothing factor, which allows the EMA to respond more quickly to price changes.
Example of EMA calculation
To illustrate how an EMA is calculated, let's consider the closing prices of an asset for 5 days:
- Day 1: $200
- Day 2: $210
- Day 3: $220
- Day 4: $230
- Day 5: $240
- Calculate the initial SMA: The first EMA starts with the SMA of the first 5 days: SMA=200+210+220+230+240/5=220
- Calculate the smoothing factor: For a 5-day period, the smoothing factor (alpha) is calculated as: α=2/5+1=0.3333
- Calculate the current EMA: For day 5, use the closing price of day 5 and the EMA of day 4: Previous EMA (Day 4)=230 Previous EMA (Day 4)=230Current EMA=(240-230)×0.3333+230=233.333 EMA actual=(240−230)×0.3333+230=233.333
- Repeat the process: For Day 6, use the closing price of Day 6 and the EMA of Day 5: Current price (Day 6)=235 Previous EMA (Day 5)=233.333 EMA actual=(235−233.333)×0.3333+233.333=233.889
Repeat this process daily, always using the most recent closing price and the updated value of the EMA to calculate the next day's moving average.
Which is the better moving average - SMA or EMA?
The main difference between the Simple Moving Average (SMA) and the Exponential Moving Average (EMA) lies in how the data is calculated and weighted. While the SMA treats all data equally, the EMA assigns greater weight to more recent data, making it more reactive to changes in price.
Simple Moving Average (SMA):
- The SMA is the most basic type of moving average. It calculates the arithmetic average of the closing prices of an asset over a specified number of periods.
- All data in the SMA has the same weight, which means that the oldest and most recent prices are treated equally in the calculation.
- Because of this uniformity in weight, the SMA can be slower to react to rapid changes in the asset's price, so in many volatile currencies it may not work for you.
Exponential Moving Average (EMA).
- The EMA, on the other hand, applies a weighting to the data, giving more importance to more recent prices.
- This means that the EMA is more sensitive to recent price movements and can provide faster signals for traders.
- The EMA is useful in volatile markets where prices can change rapidly, as it adjusts more quickly to these fluctuations.
- It is more work to calculate manually.
Delayed Indicators
- Both the SMA and EMA are lagging indicators because they are based on historical price data.
- Changes in moving averages occur after the market price has already started to move.
- For this reason, one of the main uses of moving averages is to act as trend confirmation tools, helping traders identify and confirm the direction of a trend.
Delay Mitigation
- Weighted moving averages, such as the EMA, attempt to mitigate lag by focusing on the most recent data, under the assumption that this data is more relevant for predicting future movements.
- This makes the EMA particularly useful in situations where speed of reaction to price change is crucial.
Comparison and Use
- It cannot be claimed that one moving average is inherently better than the other. The choice between SMA and EMA depends on the context and the specific needs of the trader.
- The SMA may be more suitable for identifying long-term trends due to its smoother and less reactive nature.
- The EMA is preferred in scenarios where a quicker response to price changes is needed, making it ideal for short-term trading strategies or short selling.
Advantages of Implementing a Moving Average in Trading
Despite being a basic indicator, the Moving Average in trading has many advantages that should not be overlooked:
Trend Identification
Traders make profits when they buy assets at low prices and sell them when their value increases. The moving average is very important in this regard, as it allows you to identify trends in price behavior. By smoothing out daily fluctuations, this indicator shows more clearly and objectively the general direction of asset values over time. Thus, it helps to detect upward or downward trends, facilitating more efficient decision making.
Buy and Sell Signals
When the price of an asset exceeds the moving average, what is known as a "bullish crossover " occurs. This can be interpreted as a buy signal. On the other hand, if the price falls below the average, there is a "bearish crossover", which many traders consider a signal to sell. These signals can be used to enter or exit a position in an informed manner, improving the trading strategy.
Noise Reduction
Both the financial and cryptocurrency markets can be volatile and surrounded by noise, i.e. random or temporary movements that can be distracting and make it difficult to identify trends. With the moving average it is possible to filter out that noise, allowing you to identify background trends, avoid impulsive decisions and have a comprehensive, clear and objective view of the market.
Support and Resistance.
Moving averages also act as dynamic levels of support and resistance. This means that prices tend to "bounce" off these levels. Traders use these characteristics to define entry and exit points, as well as to place stop-loss orders, which helps to better manage trading risk.
Adaptability to Different Timeframes
Moving averages can adjust to different time frames, from minutes to years, making them extremely versatile. This adaptability allows traders to apply the same basic principle of technical analysis in different contexts, whether for short-term operations such as day trading or for long-term investments.
3 Moving Average Trading Strategies
Below are three using moving averages. These are very popular.
Crossing Price and a Moving Average
This strategy involves the use of a 100-session simple moving average (SMA) on a chart.
Signals of the Moving Average in Trading:
- Buy Signal: Occurs when the price crosses the simple moving average from below to above.
- Sell Signal: Occurs when the price crosses the simple moving average from above downward.
If the price stays above the SMA, it indicates an uptrend; if it stays below, it suggests a downtrend.
2. Crossing Two Moving Averages
This strategy uses two moving averages: a fast one (30-period SMA) and a slow one (100-period SMA). Instead of watching how the price crosses the moving averages, attention is paid to the crossover between the two averages.
Strategy Rules:
- Buy signal: The fast moving average crosses above the slow moving average.
- Sell Signal: The fast moving average crosses below the slow moving average.
Although this strategy may delay the buy and sell signals due to the nature of moving averages, it provides more certain confirmation of trend change.
3. Triple Moving Average Crossover
This strategy uses three simple moving averages: a fast, an average and a slow moving average, working as a trend filter.
Strategy Rules
- For a buy position: The two faster moving averages must be above the slower moving average.
- For a sell position: The two faster moving averages must be below the slow moving average.
Keep Learning 🤓
- Moving Average in trading: all you need to know
- What is the Moving Average in Trading?
- How to calculate the moving average in trading?
- Simple Moving Average (SMA)
- Exponential Moving Average (EMA)
- Which is the better moving average - SMA or EMA?
- Advantages of Implementing a Moving Average in Trading
- Trend Identification
- Buy and Sell Signals
- Noise Reduction
- Support and Resistance.
- Adaptability to Different Timeframes
- 3 Moving Average Trading Strategies
- Crossing Price and a Moving Average
- 2. Crossing Two Moving Averages
- 3. Triple Moving Average Crossover
- Keep Learning 🤓