Moving Averages are one of the most useful technical analysis tools, if you know how to use them.
Moving averages smooth price data to help identify the current trend.
However it is important to remember that moving averages are a lagging indicator, as they are based on historical prices.
We use them because trends do not move smoothly in one direction…price tends to chop around in the short term but will follow a trend in the longer term.
Moving averages help to smooth the price action over time and therefore help to more clearly identify the longer term trend.
The two most popular types of moving averages are the Simple Moving Average (SMA) and the Exponential Moving Average (EMA)
Lengths and Timeframes.
The length of the moving average that you should follow depends on your trading style. A day trader looking at a daily chart is likely to be more focused on short term moving averages eg. 5-25 day.
Long-term traders/ investors, such as the hedge and pension fund managers mentioned previously, will prefer longer term moving averages such as 100 & 200 day moving averages.
It is again important to note that even a short term trader must therefore be aware of these longer term day moving averages. If the traders who are moving large sums of money are focused on
the 100& 200 day moving averages, then you must be aware of where these values are. An hourly chart may be telling you that there is an excellent shorting opportunity at current prices,
but if we are just approaching the 100 day moving average support then the longer term chart would be more important to follow.
Selling in to major longer term support, where large funds could be buying would clearly not be advisable!
This is why I focus on the 50, 100 & 200 period moving averages – but I use these periods on my short term (eg. 1 hour) charts also. Try using the 50, 100 & 200 hour moving averages as
support & resistance levels on your hourly chart. I find these to be reliable trading levels, when combined with other technical analysis tools.
Chart examples of moving averages working as support & resistance:
Note: This is one of the keys to successful technical analysis trading – finding areas of support & resistance from several different tools that over-lap. Not only on one time period, but across different time periods.
Remember, we look to buy at support in a bull trend but sell at resistance in a bear trend.
Remember a moving average support level is only considered broken if price CLOSES outside the line.
In the example below the black 50 DMA & the blue 100 DMA act as support levels once the price has broken above them & the price continues to move higher in a bull trend.
The price then breaks above the red 200 day moving average – although this line is downward sloping, it still manages to support prices throughout the short term downward correction phase.
Eventually the price resumes the bull trend.
Look how well the 50 day moving average (black line) works as a support area throughout the next 5 months, until eventually price breaks below at the far left of the chart.
A spike through the support or resistance is common, as ‘stop-hunters’ try to shake out the weaker traders and force them to stop out of positions, but the price can then recover to close just back inside the moving average.
This signals a false break and that the trend remains intact.
A moving average ‘cross over’ is used as a trade signal.
This is one of the main reasons for using more than one moving average. The longer moving average is used to identify the longer term trend and the shorter moving average is used to generate the signals.
A bullish signal is first generated when prices move above the moving average.
The example below shows the bottoming out of the Emini S&P after the 2008 financial crisis.
Were there any clear buy signals to tell us the market had bottomed?
- The first signal was generated when the price of the Emini S&P crossed over above the 50 day moving average (black line) which was already flattening out,
indicating that the bear trend may be ending.
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. - Confirmation of this buy signal was generated when price crossed above the 100 day moving average (blue line), which was also flattening out,
indicating that the longer term bear trend may be ending.
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. - The market is now clearly in a short term bull trend. If you had begun buying on the first price cross over and added to your investment on the second cross over
you would be looking at healthy profits going forward.. - Another bullish signal is generated when the faster 50 day moving average (black line) crosses and holds above the slower 100 day moving average (blue line).
This is further confirmation that a bullish trend is being established.
This is called a ‘Golden Cross’ when a fast moving average crosses above a slow moving average.
Ideally both moving averages should be at least starting to turn higher as they cross for the best signal.
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- The first signal was generated when the price of the Emini S&P crossed over above the 50 day moving average (black line) which was already flattening out,
Important points to note when using moving average cross over signals.
Moving average crossovers produce late signals because they are lagging indicators. The longer the moving average periods, the greater the lag in the signals.
A moving average crossover system will therefore produce lots of whipsaws in the absence of a strong trend.
