Moving averages are one of the simplest technical analysis tools, getting lots of exposure in the media as well as in educational articles. Yet the full range of how moving averages can be used is generally unknown by many traders and investors. Moving averages are applicable to both short- and long-term traders alike, providing trade entry signals, market warning signals and simplifying market data. While a moving average (MA) and moving average crossover—which you’ll learn about shortly—are great tools, technical analysis and trading involves utilizing multiple tools and looking at the overall price and trend picture, never just relying on a signal indicator.
Simple and Exponential Moving Averages Explained
Two common types of moving averages are the simple and exponential. The difference between them is how each one is calculated.
Modern trading software means that calculating a moving average by hand has become obsolete, but the distinction between the different calculations is important. A five-day simple moving average, for example, tallies the closing prices for the last five days, and then divides that total by five. An exponential moving average does the same thing, except a “multiplier” is added to give the most recent price(s) more weight.
By giving the most recent prices more weight, an exponential moving average reacts quicker to price movements than a simple moving average.
Please note that all chart examples were created using Freestockcharts.com.
See Also: 25 Stocks Day Traders Love
The data used to calculate a moving average can come from a daily bar, as in the examples above, or it can come from five-minute or 15-minute price bars, for example. If you are looking at a daily chart, your charting software will calculate the moving average using daily price data. If you are looking at a 15-minute chart, the moving average uses the price data from these bars.
Figure 1 shows these two types of 50-day moving averages. The exponential moving average fluctuates a bit more since it reacts quicker than the simple moving average.
One type of moving average is not necessarily better than the other, but some traders may prefer one over the other. Short-term traders want to get in and out at opportune times, and therefore want a moving average that reacts quickly to current conditions. In this situation an exponential moving average is preferred.
Longer-term traders or investors don’t want as many trade signals; therefore, a simple moving average that is slow to react to short-term price fluctuations is generally preferred.
There isn’t a perfect moving average length; rather, the ideal moving average(s) will depend on each individual’s trade strategy and investment horizon.
The most popular moving averages are the 200-day, 50-day, 20-day, 10-day and five-day. Each of these moving averages generally appeals to a slightly different group of traders and investors. Day traders may also use a 20- or five-period moving average, but instead of being based on the last price of the day, the moving average is based on a one-minute or five-minute chart.
Long-term traders and investors will generally monitor a 200-day simple moving average, as they are only concerned with the overall direction of the market. A 200-day moving average is slow to react to market fluctuations; it filters out of a lot of the “noise” and shows traders visually the long-term market trend.
Which Moving Averages Are Most Important?
Longer-term investors as well as swing traders often monitor the 50-day simple moving average. This moving average will react quicker than a 200-day moving average. The 50-day moving average is useful for spotting medium-term trends, while the 200-day moving average is only focused on the long-term trend.
Swing traders will mostly focus on short-term trends, as they want to get in and out of the market within a matter of days or weeks. These types of traders will typically use a 20-day, 10-day, five-day simple or exponential moving averages, or a combination of them. Since these moving averages will react quite quickly to price changes, trade signals appear more often, hopefully alerting the short-term trader to opportunities.
Figure 2 shows 200-day, 50-day, 20-day and five-day simple moving averages applied to the SPDR S&P 500 (SPY) ETF.
The lower the length of the moving average the more closely it tracks the price movement. The 200-day moving average shows only the overall price trajectory, while the progressively shorter length averages track smaller and smaller price trends.
There are two general types of crossover trading strategies – a price crossover and a moving average crossover. When the price crosses a moving average it is called a price crossover. Many traders use two (or more) moving averages, so another type of crossover occurs when one moving average crosses another, such as a 50-day crossing a 200-day.
The price crossover will be addressed first. When the price crosses a moving average it indicates that a trend change has possibly started in that time frame, and therefore many traders view crossovers as important events. Depending on the length of the moving average being watched, it is possible that the trend actually changed some time before, which is often the case with longer-term moving averages such as the 200-day, but the price crossover still helps to confirm the trend reversal.
There are two types of price crossovers, bullish and bearish.
See Also: Best Stock Market Investment
What is a Crossover Trading Strategy?
Crossover trading strategy generates a BUY signal when the fast moving average (or MA) crosses up over the slower moving average and a SELL signal is generated when the fast moving average crosses below the slow MA.
A bullish crossover is when the price moves back above a moving average after being below. This action signifies that a correction or downtrend (on that time frame) is over and an uptrend is possibly commencing.
During trending markets the signals can be quite reliable, as shown in Figure 3 below. During choppy or sideways market conditions a bullish crossover is less meaningful, since there is no trend in either direction present. In such cases the trader should wait for the price to move out of the range before applying a bullish price crossover strategy.
A 50-day moving average can be used to re-enter medium- to long-term terms when the trend resumes. It can also be used to exit trades. Trade direction (long or short) should align with the overall trend. For example, during a long-term uptrend, traders and investors should focus on buying bullish crossovers.
Bullish crossovers are less important, however, when a long-term trend is down. A 200-day moving average can be used to determine the overall trend direction.
In Figure 3 the price has been moving in an uptrend, as indicated by the price remaining well above the 200-day moving average, but on a couple occasions it drops below the 50-day moving average. When the price climbs back above the 50-day moving average, this is a bullish crossover, and a buy signal. Any number of exit strategies could be used once in a trade, but one strategy is to exit the long position when a price bar closes below the moving average.
A problem with the bullish crossover strategy is that just because the price crosses above or below the moving averages, it doesn’t mean a trend is going to commence in that direction.
The iShares Dow Jones US Real Estate Index Fund (IYR) went from an uptrend to a downtrend in aggressive fashion. Figure 4 shows a bearish crossover in May, signaling to get out of any long positions acquired during the uptrend. The next bearish crossover is a signal to go short, since the trend is now down and the price passing back below the moving average indicates the downtrend is about to resume.
A bearish crossover is when the price drops below a moving average. This signifies a potential change in direction on that time frame. A bearish crossover can be used as a signal to exit long positions, as shown in Figure 3, or it can be used to enter short positions as shown in Figure 4 below.
During choppy or sideways market conditions a bearish crossover is less meaningful, since there is no trend in either direction present. In such cases it is best to wait for the price to move out of the range before applying a bearish price crossover strategy.
The next type of crossover is a moving average crossover. This occurs when two or more moving averages of different lengths are used, and one crosses the other. Moving average crossovers are often called golden crosses and death crosses, depending on the direction of the crossover. Moving average crossovers, similar to price crossovers, can also be referred to as bullish and bearish crossovers.
RELATED: Best Stock Advisor Sites
A golden cross is any time a shorter moving average crosses above a longer-term moving average. It signals that the recent trend is moving higher and is an indication to buy.
Several golden crosses occurred in the SPDR Dow Jones Industrial Average ETF (DIA), shown in Figure 5. The moving averages used—a 10-day and 15-day—will only reflect short-term to medium-term trading signals (weeks to months).
Ideally, trades are only taken in the direction of the longer-term trend. Since the trend is up (price is making higher highs and higher lows overall) the golden crosses are used as buy signals. When the shorter-term moving average crosses below the longer-term moving average, this signals to get out of the long position; this is called a death cross.
The most popular golden-crosses, which are often referenced in the media, are when the 50-day moving average crosses above the 100-day or 200-day moving average. It indicates that the longer-term downtrend is ending, and an uptrend is potentially underway.
See Also: Ten Commandments of Futures Trading
In Figure 6 the SPDR Gold Trust (GLD) has been in a long-term uptrend. The price is trading above the 100-day moving average (pink), and the 50-day moving average is above the 100-day. In early 2013, the shorter moving average drops below the longer moving, indicating a trend change to the downside.
A death cross is any time a shorter moving average crosses below a longer-term moving average. It signals that the most recent price action is moving lower and is an indication to sell or short.
RELATED: Motley Fool Stock Advisor Review
Since the 100-day and 200-day average are often used to determine the long-term trend, when a 50-day moving average crosses below it, it usually indicates a significant downtrend is already underway. When the signal occurs, long positions are exited and short positions can be taken.
Death crosses can occur on shorter time frames as well, such as utilizing a 10-day and 15-day moving average like in the golden cross example. In such cases, investors should ideally only take short positions when the overall trend is down (overall price is making lower highs and lower lows).
The most popular death cross, which is often referenced in the media, occurs when the 50-day moving average crosses below the 100-day or 200-day moving average.
Moving averages can also be applied to almost any indicator. Adding a moving average to volume can show whether volume is rising with the price—a confirmation signal—or if it is falling as the price is rising – a warning signal.
Figure 7 shows a moving average (15) applied to a 14-day RSI. In this case the moving average is not based on the price, but rather smooths the RSI data. Similar to a golden or death cross, when the RSI crosses through the moving average, it signals a potential change in direction.
The Silver Trust (SLV) ETF is in an overall downtrend; therefore, similar to other moving average strategies discussed, the most powerful signals are those that align with the trend direction. Several potential short trades have been marked on the chart. When the RSI drops back below the moving average it indicates the downtrend is resuming and short trades can be taken. When the RSI crosses above the moving average, those short trades are closed.
If the overall trend is up, look for buy signals as the RSI crosses the moving average from below. Exit the long trades when the RSI crosses back below the moving average.
Applying a Moving Average to Other Indicators
Moving averages provide multiple ways for traders and investors to trade and analyze the market. There isn’t a single moving average or combination of moving averages that is ideal; rather, each individual will need to find moving averages that suit their trade timeframe or investment horizon. Traders shouldn’t rely solely on moving averages, but should use these tools in conjunction with price analysis and other technical analysis methods.
Disclosure: No positions at time of writing.