What are moving averages, and how to read them

Moving Averages: A Comprehensive Guide to Technical Analysis

Introduction

Moving averages are fundamental tools in technical analysis that help traders identify trends and make informed trading decisions. Their primary purpose is to smooth out price data by filtering market noise and short-term price fluctuations, allowing traders to focus on the underlying trend.

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Understanding Moving Averages

A moving average is a continuously calculated average of an asset's price over a specified period. As new price data becomes available, the oldest data point is dropped, and the average "moves" forward. This rolling calculation creates a smoother line representing the asset's price trend.

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Types of Moving Averages

Simple Moving Average (SMA)

The SMA gives equal weight to all price points within the calculation period.

Exponential Moving Average (EMA)

The EMA assigns greater weight to recent prices, making it more responsive to new information.

Weighted Moving Average (WMA)

The WMA assigns incrementally higher weights to more recent prices.

Double Exponential Moving Average (DEMA)

DEMA reduces lag by giving even more weight to recent prices while maintaining smoothness.

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Practical Applications

Trend Identification

• Uptrend: Price consistently above the moving average.
• Downtrend: Price consistently below the moving average.
• Sideways: Price oscillating around the moving average.

Support and Resistance

Moving averages often act as dynamic support and resistance levels:

• In uptrends: Moving averages act as support.
• In downtrends: Moving averages act as resistance.

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Calculating Moving Averages

Moving averages help smooth price data to identify trends in financial markets. The most common types are:

• Simple Moving Average (SMA): The arithmetic mean of closing prices over a set time period.

Formula:

SMA = \frac{\sum P}{N}

where P = closing prices, N = number of periods.

Exponential Moving Average (EMA)

EMA is based on the most recent price points when compared to SMA. For example, to calculate EMA for the last 20 days, you first need to calculate SMA for the same period (you can check how to do it in the previous paragraph). After SMA is calculated, calculate the multiplier for smoothing (weighing) EMA. Usually, the following formula is used to do so.

2 ÷ (number of observations + 1 - multiplier

So, for a 20-day moving average, it will be:

2/(20+1)]= 0.0952

Finally, we can calculate EMA for the current period. For that, we use the formula:

EMA = Closing price x multiplier + EMA (previous day) x (1-multiplier)

EMA for the most recent periods has more weight than EMA for longer periods. 

Weighted Moving Average (WMA)

WMA is another important moving average that indicates a trade direction. This average gives more weight to recent data points and less weight - to more remote data points, just like EMA does. 

WMA is calculated by multiplying a point in a data set by the weighting factor. The weight for points is distributed equally from 1% to 100% from the most remote to the most recent ones.

This moving average helps traders to determine what trend is in the market. When the prices are above the WMA, the market is in an uptrend. If the prices are below the WMA, the market is in a downtrend.

Double Exponential Moving Average (DEMA)

DEMA is a more accurate version of EMA. It allocates more weight to the recent data, thus reducing the lag. That’s why DEMA can be used by short-term traders to spot the reversal of a market trend asap.

To calculate DEMA, do the following:

• Select for which period you want to calculate it (a lookback period). It can be 5 periods, 10 periods, or any other lookback period.
• Calculate EMA for that time. This will be EMA(n).
• Now, apply the EMA with the same lookback period to EMA (n) - you get a smoothed EMA. 
• Multiply two times the EMA(n) and subtract the smoothed EMA, and you get a value for the DEMA.

DEMA is not a double EMA, as you can think. It doubles the EMA but cancels the lag by subtracting a smoothed EMA.

DEMA is pretty straightforward. If the asset price is above the DEMA, and the DEMA is rising, it confirms the uptrend. If the price is below the DEMA, and the DEMA is falling, there is a downtrend.

DEMA is sensitive to market volatility and reacts to changes faster than the above-mentioned averages that’s why it is often used by day traders and swing traders.

Moving Average Crossovers

Golden Cross

A bullish signal occurring when a shorter-term moving average crosses above a longer-term moving average.

Death Cross

A bearish signal occurring when a shorter-term moving average crosses below a longer-term moving average.

Technical Indicators Related to Moving Averages

Moving Average Convergence Divergence (MACD)

MACD consists of:

• MACD Line: The difference between two EMAs (e.g., 12-day and 26-day EMAs).
• Signal Line: A 9-day EMA of the MACD line.
• MACD Histogram: The difference between the MACD line and the signal line.

Bollinger Bands®

Bollinger Bands® combine moving averages with statistical analysis to measure volatility and identify overbought/oversold conditions.

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Moving Average Strategies

Multiple Moving Average Strategy

Using multiple moving averages of different periods can confirm trends and identify entry/exit points:

• Short-term (10-20 periods)
• Medium-term (50 periods)
• Long-term (200 periods)

Limitations and Drawbacks of Moving Averages

Lagging Nature

Moving averages are lagging indicators by design, generating signals after price movements have begun.

False Signals

• Whipsaws in choppy markets
• Multiple crossovers during consolidation periods
• False breakouts during low volatility

Conclusion

Moving averages are versatile tools forming the foundation of many trading strategies. They work best when:

• Combined with other technical indicators.
• Used within a comprehensive trading strategy.
• Applied with appropriate time periods for your trading style.
• Confirmed by price action and volume.

Remember, moving averages are lagging indicators and should be part of a broader analytical framework rather than used in isolation.

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Bottom Line

Moving averages help to identify the trend rather than give trading signals because they are lagging indicators. They shall be used with other tools, such as momentum indicators or price action to make correct decisions.