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Moving Averages (MAs) provide a set of very useful indicators for tracking trends and trend reversals.
The Moving Average is a lagging indicator, or trend following formula, that smoothes the volatile swings in a market.
MAs are used to track the progress of a trend and to signal when a trend has ended or reversed.
There are 4 common types of moving averages: simple, linearly weighted, exponential and variable.( See Table below for Types of Moving Averages)
The Moving Average (MA) is one of the simplest, yet most versatile and widely used of all technical indicators. The MA attempts to tone down the fluctuations of market prices to a smoothed trend, so that distortions are reduced to a minimum. MAs help in tracking trends and signalling reversals. You could think of the MA as a curved trendline, fitting itself to the market.
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. As with trendlines, the MA often provides an area of support and resistance. The more times an MA has been touched (i.e., acts as support or resistance) the greater the significance when it is crossed.
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. Exponential and weighted averages apply more weight to recent prices. 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.
Type of MA
(This is the most commonly used MA)
Use of multiple MAs can provide good signals
Short term 10-30 day
Mid term 30-100-day
Long term 100-200+day
There is no perfect time span
Crossover of short term through long term
Crossover of MA by price
With this MA, data is weighted in favour of most recent observations.
Has the ability to turn or reverse more quickly than simple MA.
Warning of trend reversal given by change in direction of the average rather than crossover.
An exponential (or exponentially weighted) moving average is calculated by applying a percentage of today's closing price to yesterday's moving average value. Exponential moving averages place more weight on recent prices.
Crossover of short term through long term
Crossover of MA by price
An automatically adjusting exponential moving average based on the volatility of the data.
The more volatile the data, the greater the weight given to the current data and the more smoothing used in the moving average calculation.
The variable MA is able to compensate 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.
MAs should always be used in conjunction with other indicators because of the potential for false signals (whipsawing) and, particularly during sideways channels. MAs can be calculated on a security's open, high, low, close, volume, or on any other indicator. Indicators which are especially well-suited for being used with moving averages include MACD, Price ROC,Momentum and Stochastics. A moving average of another moving average is also common.
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.
Moving Average Price crossover
A price break upwards through an MA is generally a buy signal, and a price break downwards through an MA is generally a sell signal. As we have seen, the longer the time span or period covered by an MA, the greater the significance of a crossover signal.
If the MA is flat or has already changed direction, its violation is fairly conclusive proof that the previous trend has reversed.
False signals can be avoided by using a filtering mechanism. Many traders, for example, recommend waiting for one period - that is one day for daily data and one week for weekly data.
Whenever possible try to use a combination of signals. MA crossovers that take place at the same time as trendline violations or price pattern signals often provide strong confirmation.
Multiple Moving Averages
It is usually advantageous to employ more than one moving average. Double and triple MAs often provide useful signals.
With two MAs the double crossover is used; a buy signal is produced when the shorter average crosses above the longer, and vice versa for the sell signal. For example, two popular combinations are the 5 and 20-day averages and the 20 and 100-day averages. The technique of using two averages together lags the market a bit more than a single moving average but produces fewer whipsaws.
The triple crossover method is also popular, using three moving averages. The most widely used triple crossover system is the popular 4-9-18-day MA combination. A buy signal is generated when the shortest (and most sensitive) average - the 4 day - crosses first the 9-day and then the 18-day averages, each crossover confirming the change in trend.
The 200-day MA(or 40-week MA), should be carefully watched as a pivotal level of support or resistance for the long-term trend. Many people watch carefully when the 200-day MA is approached by the price. The relationship between the price and its 200-day MA can often provide excellent buy or sell signals.
The 200-day MA is also particularly significant for the various indexes, such as the Dow Jones or NASDAQ. A crossover of this MA has often signalled a correction or period of consolidation.
Moving averages can also be calculated and plotted for other indicators, not just the price. A continued upward movement by the indicator is signified by the indicator rising above its moving average. A continued downward movement is signified by the indicator falling below its moving average.
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