What is the Moving Average (MA)?
Technical Analysis (TA) is nothing new in the trading and investment circles. From traditional portfolios to cryptocurrencies like Bitcoin and Ethereum, the use of TA indicators is only for a simple purpose: using available data to make decisions that can potentially lead to desired results. As markets have become increasingly complex, hundreds of different types of TA indicators have appeared for the past decade, but Moving Average is the most commonly used.
Although there are different variations of Moving Averages, their main purpose is to make the trading chart clear. It is done by evening the charts to create a trend indicator that can be easily interpreted. Because Moving Average is based on historical data, so it is considered trailing indicators, in other words, it only shows changes that have occurred. Even so, it still has a significant effect and helps identify market trends.
Types of Moving Averages
There are many different types of Moving Averages that can be used by traders not only in intraday and swing trading but also in long-term setups. Although there are different types, the MAs are usually divided into two distinct types: Simple Moving Averages (SMA) and Exponential Moving Averages (EMA). Depending on the market and the desired result, traders can choose which indicator is most useful for their setup.
In this article, we will explain to you two main types of Moving Averages:
- Simple Moving Average (SMA)
- Exponential Moving Average (EMA)
Simple Moving Average (SMA)
This is the simplest Moving Average type, which is calculated by taking the closing price of X sessions and dividing by X.
For example, if you put a 5-period SMA (SMA 5) on the 1-hour time frame chart, you need to add the closing price of 5 times 1 hour earlier, and then divide this number by 5. Thus, you have calculated an average of the closing prices of 5 hours.
Keep going after 1 hour (ie you add 5 times of the nearest 1 hour) and connect them together, you will get the average line.
Another example, if you want to find the 5-period Moving Average (SMA 5) on the time frame of the 10-minute chart, you need to add the price of 5 times 10 minutes of the previous 50 minutes and then divide by 5.
Most trading tools have already done this calculation, so you do not have to worry. The above explanation just aims to help you understand how those tools work, so you can use them better. Understanding how they work will help you create and align trading methods as the market changes.
Like most indicators, the MA is also late. Because the MA is used to calculate the average of the past price which only helps you to see the overall direction of the past price period. Your job is to research and find out what those past data will forecast in the future.
This is the example of how MA smoothe the price
In the chart above, we placed 3 different SMA lines on the 1H chart of USDCHF. As you can see, the larger the period of the SMA is, the slower it will be comparing to the price.
Note that the SMA 62 is further away from the price than the SMA 30 and SMA 5. This is because SMA 62 added the closing price of the previous 62 periods and divided it by 62. The longer the number of periods is, the slower the MA responds comparing to the price.
The SMA on this chart shows you the overall direction of the market at present. As above, we can see the prices are trending.
Instead of looking at the current value of the market, the MA gives us a wider view and we can measure the overall direction of future prices. With the use of SMA, we can say whether the price is trending up or down or moving sideways.
One problem of SMA is that it is easily penetrated by surprise. When this happens, it often gives false buying/selling signals. At that time, we might think that a new trend had formed but the fact is nothing has changed.
Exponential Moving Average (EMA)
As mentioned above, SMA is susceptible to the impact of unexpected penetration. Let’s look at the example below with SMA 5 on the daily chart of EURUSD.
The closing prices for the past 5 days are as follows:
Day 1: 1.3172
Day 2: 1.3231
Day 3: 1.3164
Day 4: 1.3186
Day 5: 1.3293
The calculation of SMA is as follow:
(1.3172 + 1.3231 + 1.3164 + 1.3186 + 1.3293) / 5 = 1.3209
Imagine that on day 2 we have a news release and make the EU price falls to 1.3000. Let’s see its impact on the SMA 5 line:
Day 1: 1.3172
Day 2: 1.3000
Day 3: 1.3164
Day 4: 1.3186
Day 5: 1.3293
The SMA 5 line will be recalculated as follow:
(1.3172 + 1.3000+ 1.3164 + 1.3186 + 1.3293) / 5 = 1.3163
As a result, the SMA line has been much lower than it was in the beginning and it makes us think that the price has reversed, but in reality, Day 2 is only due to bad news.
The point here is that sometimes the SMA is too simple and doesn’t help filter out all the distracting signals. Therefore, we need to use the Exponential Moving Average (EMA).
The EMA will place weighting in the most recent periods. As in the example above, the EMA will focus on prices at the nearest current days, which are days 3, 4 and 5. This means that day 2 will be less valuable, and will not have a significant impact as SMA.
It shows that the EMA pays more attention to near price action than data that is too far in the past. Let’s follow the example on USDJPY’s 4H chart below to see the difference between SMA and EMA on the same data chart.
Note that the red line (EMA 30) seems close to the price than the green line (SMA 30). This means it more accurately represents the most recent price movements.
The reason is the EMA is focused on the latest price data. When trading, it is important to pay attention to price action at the present time rather than what it showed last week or the previous month.
The differences between SMA and EMA
First, let’s about EMA. If you need an MA that can quickly react to price, a short-term EMA will be suitable. It helps you catch trends quickly and earn high profits. The truth is that the faster you catch the trend, the longer you can follow the trend, and the more profitable it will be.
However, the downside of the EMA is that sometimes you will catch the wrong signal during the period of flat price, because the EMA is too sensitive to the price, so sometimes you think that a new trend has formed but is really just an abnormal fluctuation of the price.
Second, SMA is the opposite situation. If you need an evener and less price-sensitive MA, a longer-term SMA is a right choice. SMA can work well on long time frames and can show what the current trend is.
Although SMA responds slowly to price, it can save you from wrong signals. However, the downside is that sometimes we can be slow and miss some good entry point signals.
In fact, none of them is the best, it is up to the user’s decision.
Many people use different types of Moving Averages to analyze in order to have many aspects of the problem. They often use long-term SMA to find trends, then use the short-term EMA to find entry points.
Each person is suitable for using different types of MA. To find the MA that suits you, the only way is to try on the graph and look at the past.
The uses of the Moving Averages
1) Use moving averages to identify trends
The most common way of moving averages is to help you see the trend. To do this, you just need to open an MA on the chart, when the price is above the Moving Average, it is a sign of an uptrend and vice versa.
The problem is that this is so simple. Take a look at the example below with USD / JPY in a downtrend but there was published news that made the price increased.
You see that the price is above the moving average and starts to think “it looks like the price has changed direction and this might be the time to buy” and you did this.
As a result, you have received a false signal. The above reaction is only an impact due to the news, the downward trend continues and the price goes down steadily.
What many traders have done and you should do is to use more MA lines on the chart instead of only one. They will give us a clearer signal as to whether the price will rise or fall based on MA.
Here is a clearer explanation:
In an uptrend, the “fast” MA line will be above the “slow” MA line, opposite with the downward trend. For example, suppose we have 2 MAs are MA 10 and MA 20. Take a look at the chart below with the USDJPY currency pair on the daily time frame.
In an uptrend, the SMA 10 is above the SMA 20. As you can see, you can use the MA to help consider an uptrend or downtrend. Combining them with your knowledge of trendlines, you will make better decisions about whether to buy or sell.
You can also place more than 2 MA lines on the chart, but keep in mind that “the fast MA line is above the slow MA line when the trend is upward, and opposite”, so you can see the trend.
Trading when the MAs intersect
This way is to place multiple MA lines on the chart and wait for their crossings. If an MA line crosses other MA lines, then it can be a signal that the trend is changing, thereby you have a good chance to enter the order.
See the example on the daily chart of USD / JPY to explain the transaction with the MA cross.
From about April to July, the pair is in a good uptrend. It peaks at the price range of 124.00 before slowly descending. Around mid-July, we see SMA 10 cut down to SMA 20.
And what happens next? It is a good downtrend.
If you have placed a sell order at the crossroads of the MA, you are already making a profit.
Of course, we don’t always earn 1000 pips, 100 pips or even 10 pips, in some cases we will lose money, which means we need to place profit point and stop-loss point before entering the order. We cannot enter orders without a clear trading plan.
One notice when trading with the crossing of the MA is that this method usually works well during periods which price is trending or fluctuates sharply, but not well during the periods of flat prices. For the sideways period, the price will often cut up and down, so you will meet a lot of stop-loss points.
Support and dynamic resistance
Another way to use MA to view it as support and resistance. We call it “dynamic” because it differs from traditional resistance as horizontal lines. The MAs that change based on price movements should be considered “dynamic”.
There are many traders who use MA as important resistance or important support. Many traders will place a buy order when the price falls and reaches the support points of the MA. On another hand, they will place a sell order when the price rises and reaches the resistance points of the MA.
For example, let’s watch the 15-minute chart of the GBP / USD currency pair with the EMA 50. This EMA line has acted as a support and dynamic resistance.
Looks like the EMA has done well whenever the price reaches the EMA 50, it plays the role of resistance to push prices back down.
One thing you should keep in mind is that the MA is just like normal support and resistance, which means that the price does not reach and bounce off perfectly, but sometimes it can overcome a bit before turning back on the right track.
To solve this problem, many traders use the 2 MA lines and only buy or sell when the price falls between the two MA lines. This space is called the “zone.”
Here is an example of the 15-minute chart of GBP / USD below with SMA 10 and SMA 20:
From the chart above, you can see the price crossed a bit above SMA 10 but then fell back. The zone between MAs can be considered as a resistance or support area.
The collapse of support and dynamic resistance
Now, you know the MA lines can act as support and resistance. Combining the 2 MA lines, you can have 1 support and resistance area. However, you need to know that they can be collapsed.
See the example of the EMA 50 on the GBP / USD 15-minute chart:
In the chart above, we see the EMA 50 acts as strong resistance in short-time as GBP/USD continually goes up and down. However, the price broke out of EMA and increased sharply, then returned to EMA 50. At this time, the EMA 50 is back acting as price support.
In general, we conclude that the MA can act as support or resistance.
Keep in mind that the MA changes regularly, meaning that we only need to open it on the chart and do not need to look back on the past prices to look for support and resistance rates ahead.
The difficult problem is to find the MA which suits you.
Conclusion
There are many types of Moving Averages (MA). The two most common types are the Simple Moving Average (SMA) and the Exponential Moving Average (EMA).
- SMA is the simplest MA type and also the most easily affected by abnormal price movements.
- The EMA is the MA type that places a lot of emphasis on present price movements, which means it focuses more on the movements that are currently taking place.
- It is more important to know what traders are doing at the moment rather than what they did last week or last month.
- SMA is more even than EMA.
- Long-term MA is more even than short-term MA
- EMA can help detect trends quicker, but also make more mistakes.
- More even MA lines react more slowly to prices but they can help avoid abnormal price movements and false signals. However, because of the slow reaction of MA, it can cause you to lose opportunities for some great entries.
- The MA can be used to identify trends, entry points, and trend endpoints.
- The MA can be used as either support or dynamic resistance.
- A good way to use MA is to apply different MAs on the same chart to see both short-term and long-term fluctuations.
Though it’s easy to use MA, it is rather important to find the MA that suits you best. Therefore, it’d be better to try out different MAs and select the MAs that you feel suitable.
Many traders use MA to analyze trends, while others use MA for support and resistance. Whichever method you choose, keep in mind you need to have the MAs that suit your trade plan.
Other factors to consider
The above examples are all daily data, but it is not compulsory for MA analysis. Day traders may be more interested in the fluctuations of a security that has taken place in the past two or three hours, not two or three months. Different time frames can all be included in equations used to calculate moving averages, as long as the time frames included a match with trade strategy, so the data can be relevant.
A major drawback of MA is latency. Because the MA is an indicator that comes after considering previous price action, it often gives out late signals. For example, an intersection point in an uptrend might suggest buying, but this point only occurs after a significant price increase. This means that even if the uptrend continues, potential gains may not continue around the time of price increase or intersecting signal. Or even worse, a false gold-cut signal can cause a trader to buy a peak just before a price drop (these false buy signals are often called bull trap).
Moving averages are strong TA indicators and are among the most widely used indicators. The ability to analyze market trends based on data gives insight into how the market is performing. However, keep in mind not to use only MA and intersecting signals, but rather combine them with different TA indicators to avoid false signals.
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