How to Trade With the Moving Average Indicator
The moving average indicator is one of the easiest indicators for new traders to understand, yet it is also one of the most versatile and widely used, suitable for traders of all styles and on all time frames.
In this article, we will take an in depth look at the moving average indicator and why it is an essential trading indicator that can be used for identifying trends. But this is not its only use. The indicator has other wider applications for helping sift through the noise of price fluctuations.
Table of Contents
Moving Average Indicator: An Introduction
You can calculate a moving average over any data set that changes with time, but in technical analysis, its most common usage is with the price of an asset.
A moving average (MA) is a continuously calculated value of the mean average of the price over a specified time period. The “moving” part of the name is there because we calculate a new value as each time frame advances, so that the value of our average adjusts with changes in the price.
So, for example, we might use a 30-day moving average. The value is the mean average of the price over the previous 30 days. In other words, we add up each of those 30 closing prices and then divide by 30. This value is calculated each day, discarding the oldest value in the data set, in favor of the most recently occurring day.
The effect of a moving average is to smooth out price fluctuations. This helps us to look beyond transitory or insignificant blips in price, and instead see the longer-term tendency of the market.
Economists and analysts have been using moving averages in their studies long before the advent and availability of personal computers arrived to aid their calculations. Thankfully, these days, calculating moving averages over pretty much any desired timeframe has never been easier, requiring simply the click of a button.
Throughout this article, we will be looking at various applications of the moving average indicator. If you wish to use indicators like the moving average, you must trade on a platform that supports them. Why not check out MetaTrader if you haven't already? Download and begin trading on the world's most advanced multi-asset platform right now! For more, click the banner below:
The Moving Average: Long-Term Indicators
Identifying the Long-Term Trend
Price charts can sometimes be confusing for traders. They may get distracted by the many ups and downs that price action can create and lose track of the trends and the overall picture.
Long-term Moving Average indicators help traders keep their focus, quickly allowing them to understand whether a trend is present and, if so, what its direction is.
The long-term moving average indicator keeps traders on the right side of the financial markets. It helps traders to avoid risky reversal setups, and allows them to enter setups that are keeping with the overall trend.
Key Decision Zone: Bounce or Break
Identifying the trend is not the only advantage of using a long-term moving average indicator. Price tends to respect and stop at the long-term MA levels. The MA levels are key and critical decision zones for either a trend continuation or a larger reversal:
- If the price breaks the long-term MA, a reversal is likely
- If the price bounces slowly at the long-term MA, the price can break both ways
- If the price bounces strongly at the long-term MA, a trend continuation is likely
The reaction of price at the long-term moving average is certainly valuable information to take into consideration. Of course, it is best to take other factors into consideration as well, such as Fibonacci levels and other technical indicators to find a confluence of support and resistance.
Traders can trade these breakouts and bounces by, for instance, waiting for Japanese candlestick patterns to indicate whether a bounce or breakout is occurring. Traders can then judge whether the candle pattern indicates for a trade setup or not.
The Moving Average: What are the Best Levels?
Most traders tend to use MAs around 100 to 200 period for the long-term. The two common choices that a trader may use are a Simple Moving Average and an Exponential Moving Average.
The Exponential Moving Average (EMA) gives more weight to more recent price values. The amount by which this weighting decreases for each successively older price value is exponential, hence the name. On the other hand, the Simple Moving Average (SMA) gives equal weighting to all price values incorporated in the time frame.
Popular MA settings are often around levels such as 100, 150 and the 200 period. Some traders also use Fibonacci sequence levels for their moving average indicator such as 89, 144, or the 233 period.
That being said, short-term and medium-term moving averages remain important too, but for different purposes than that of the long-term MA. Short-term MAs are best used for determining momentum and support and resistance zones. Medium-term MAs are useful for assessing retracement and correction targets.
Short-term moving averages are anything between 0 and 20 periods, whereas medium-term MAs are usually between 20 and 100. These settings can, and do, vary from trader to trader, but this is a general guide. Many traders in fact add all three types of moving averages to their chart:
- One moving average around 5-20
- One moving average around 20-100
- One moving average that is 100+
The advantage of applying all three moving average indicators to the chart is that traders are able to get a fuller view on various tendencies of the price.
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Moving Average Indicator: Trend and Momentum
The main value of using a moving average indicator is to quickly determine the presence and direction of trend and momentum. Here are three statements to help you distinguish between trend and momentum:
- An overall trend occurs if the price moves away from the long-term MA: higher in an uptrend or lower in a downtrend
- A short-term trend is visible if the price moves away from the medium MA: higher (bullish) or lower (bearish)
- Momentum is visible if the price moves away from a short-term MA: higher (bullish) or lower (bearish)
The best trending movements are when the price, the short-term trend, and the overall trend are aligned in one direction. For an uptrend this means that the price is above the short-term MA, and the short-term MA is above the trend MA. For a downtrend this means that the price is below the short-term MA, and the short-term MA is below the trend MA.
The chart lacks a trend or momentum if the price is moving around the MA - which is known as a correction - or if it is actively moving back towards the MAs – which is known as retracement or a pullback.
A passive correction is when the price goes sideways and the moving averages catch up with the price, whereas an aggressive retracement is when the price moves impulsively back towards the moving average indicator.
The Hidden MA Gem
MAs are valuable as support or resistance, when the market is trending and moving impulsively. As a market gains momentum the price will still make smaller pullbacks along the way. In these cases, the moving average indicator can often turn into a solid support or resistance level.
One approach to visualise support or resistance is by applying the same MA in three different ways, such as:
- 21 MA of the price close
- 21 MA of the price low
- 21 MA of the price high
Together, these three moving average indicators create a zone of support and resistance. The biggest advantage of having three MAs act as support and resistance, rather than just one, is that the market tends to respect a rough range, rather than a single support or resistance point, so a price zone always has more value than a single price point.
It is important to note that the MAs will not act as support or resistance if the market is in a large consolidation (i.e. not trending).
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Divergence and Reversal Targets
Eventually a trend will end, and a phase of either consolidation or reversal will start. The chance of pullback increases substantially once the trend loses its momentum, which creates a divergence between the highs (in uptrend) or the lows (in downtrend). Divergence is a strong indication of either a pending retracement within the trend or the end of the trend and a subsequent reversal.
Divergence is when an asset's price is moving in the opposite direction of a technical indicator, it can be identified using an oscillator (below we use the Stochastic).
If the price is reaching new highs, but the oscillator is achieving lower highs, then positive divergence is taking place. If the price is reaching new lows, but the oscillator is achieving higher lows, negative divergence is taking place.
The moving average indicator can then be used in various different ways. For instance, when the price starts its counter-trend move it can be used as an entry for further trend continuation or a target for a reversal trade.
Here are some important concepts to consider when using a moving average indicator with the stochastic oscillator in Forex trading:
- A lack of divergence could see the price retrace to and bounce at a shallow 8 MA
- A single divergence on a one-hour chart or lower will mostly create a slight retracement, which means that the price could pull back to and bounce at the 21 MA
- A single divergence on a four-hour chart or higher will mostly create a sturdy retracement, which indicates a good chance of price retracing back to, and bouncing at the 144 MA
- A double divergence should initiate a stronger pullback, which means that the price pulls back to a 144 MA
- Divergences on multiple time frames will increase the chance of a reversal, which means that the price could pull the 21 MA to the opposite side of the 144 MA
The targets featured in the image above are of course rough indications. It is important to realize that the targets could be missed before the trend continues, and to analyze each financial instrument on its own merit and within its own context.
Final Thoughts
The moving average indicator has many applications in trading. Its beauty lies in the fact that you can make it as simple or as complicated as you need.
At the simpler end of the spectrum, the indicator can help to smooth out fluctuations within a choppy market. This makes it easier to see what is happening, without being distracted by the noise of volatility. Another basic use is as a rudimentary yardstick for the trend of the market over a given timeframe. A rising MA suggests an upward trend, and a falling MA suggests a downtrend, as we have seen.
Of course, you can choose to increase the complexity from there, with exponentially weighted-moving averages or by using the moving average indicator in conjunction with an oscillator to spot divergence.
For those of you who are keen to take your knowledge of moving average indicators to the next level - you may be interested in reading our other article ‘The Moving Average Strategy Guide’.
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Frequently Asked Questions
What is a Moving Average Indicator?
The Moving Average Indicator is a popular technical analysis tool used in financial markets to identify trends and smooth out price fluctuations over a specified period. It calculates the average price of a security (e.g., stock, currency pair, or commodity) over a specific time frame, continuously updating as new data becomes available. The indicator helps traders and investors to spot potential trend changes and make informed decisions based on the price movements.
How is a Moving Average Calculated?
To calculate a Moving Average, you add up the closing prices of the security for a specified number of periods and then divide that sum by the number of periods. As new data comes in, the oldest price is dropped from the calculation, and the most recent price is added. This process repeats to create a continuous moving average line. Commonly used time frames for Moving Averages include 50-day, 100-day, and 200-day periods, although other periods can be employed depending on the trader's preferences.
What does the Moving Average Indicator indicate?
The Moving Average Indicator helps traders to understand the direction of a trend and potential support and resistance levels. When the price is above the Moving Average line, it may indicate an uptrend, and when it's below, it may suggest a downtrend. Crossovers between different Moving Averages (e.g., the 50-day crossing above the 200-day) can also be used to identify potential buying or selling opportunities. Moreover, the slope and distance of the Moving Average from the current price can give traders insights into the strength of the trend. However, like any technical indicator, it has limitations and should be used in conjunction with other tools and analysis techniques for more comprehensive decision-making.
Other articles that may interest you:
- How to Trade with the DeMarker Indicator
- Hunting Key Levels With the Envelopes Indicator
- Various Applications of the ZigZag Indicator
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