If you are a technical trader, you should definitely know the six different uses of moving averages. No excuses.
They are one of the most versatile indicators in technical analysis. Everyday, millions of traders, from small retail ones to big institutional, use them to study the market.
Moving averages are used for gauging the direction and strength of a trend, or to find potential zones of support and resistance.
But before to talk about the different uses of moving averages, we should understand what they actually are.
What Is a Moving Average? Construction and Main Scope
By a mathematical point of view, moving averages are simply rolling averages of price data. The time-period of the moving average is the interval of time on which price is averaged.
Their main usage is to filter price action. They help us to remove market noise, providing a smooth representation of market action, as you can see in the example below:
Moving averages help traders to focus only of general price direction, filtering out all the erratic movement of price.
Remember: the higher the time-period of the moving average, the smoother is the average and so the higher the filter to price action.
It’s important to remember that moving averages are not influenced by the scale of charting used: they are derived from numerical data, and they don’t have a geometrical component like for example trendlines.
Moving Averages are Lagging Indicators!
Understand this passage is crucial if you want to study deeply what are the uses of moving averages.
These indicators are based on historical data. The result is that you are comparing actual price with previous price action (represented by moving averages).
The delay, rise at the increase of the time period used for the construction of the moving average. For example, MA averaged on 50 periods is faster than MA averaged on 200 periods.
In other words, we can say that short-term moving averages react quickly to price action, while longer ones tends to be less reactive:
Moving Averages Weighting Methods
Moving averages are not versatile considering only their uses, but even if we take in consideration how they are build.
There are a number of different ways to average data: the difference consist in the “weight” attributed to price informations from which moving averages are computed.
The method of average used, determine the sensitivity of these overlay indicators toward latest prices.
Let’s consider a Simple Moving Average (SMA). In this case, an equal-weight is assigned to all the prices considered for the computation of the rolling average. This is not true for Exponential Moving Averages (EMA): in this case indeed, latest prices have a higher weight compared to past ones. For this reason, we can say that EMA are more sensitive to price action respect SMA.
Look at the following example, in which I plotted a SMA and an EMA both based on 50 periods:
EMA is faster than SMA, even if both are calculated in the same amount of time. The only difference between them is the weighting method used.
Simple and exponential moving averages are just two of the method for construct moving averages: for the purpose of this article I will not talk about the different weighting methods, since I think they require a more specific blog post.
Uses of Moving Averages: Six Main Applications
I love these indicators because of their versatility. There are at least six main different uses of moving averages in technical analysis. We will now cover each one of them more in details.
1. MAs as Filter of Price Action
I’ve already mentioned that moving averages are exceptional for filter-out the erratic movement of the markets.
They smooth the action of price, isolating price trend from market noise: that’s the main reason why often moving averages are used for determine the market phase of a market.
But please, be careful! You should remember that moving averages are lagging indicators, and the higher the time period considered, the higher the delay of the indicator.
2. Trend and Market Phases Identification
Talking about the different uses of moving averages, we cannot avoid to mention the fact that, for novice traders in particular, these indicators represent an excellent way to gauge the overall direction of the market.
Considering a practical point of view, in order to identify in which market phase we are (consolidation or trend), we need at least two moving averages. A faster one and a slower one.
Look at the following example, in which I used a 50 periods EMA and a 100 periods EMA:
The general rule of thumbs is: whenever there’s a cross, we might experience a change in the underlying trend. But as you can see, even the number of crosses is quite relevant.
We have a:
- Consolidation phase – whenever moving averages start to converge, changing constantly their positions. In this case there isn’t a clear and defined trend;
- Trend phase – whenever moving averages start to diverge one from another, as you can see in the green circle on the chart above.
3. Gauge the Strength of a Trend
We’ve seen that whenever moving averages start to diverge, we are in a trend condition. But what if we want to know the strength of this trend?
Well, moving averages can help even in this case. whenever short, medium and long term averages start to diverge, pointing in the same direction, than we are in a strong trend.
In an opposite way, if those averages are not pointing in the same direction, we might see an early sign of weakness.
In addition to the overall direction of the moving averages, according to Mark Andrew Lim, others factors influencing the strength of a trend depends on:
- The degree of divergence between price and moving average
- The degree of divergence between different moving averages
- The angle of ascent or descent of the moving averages
4. Dynamic Barriers for Price Action
Moving averages act as dynamic support and resistance zones. They are able to halt price, making a sustain to its action. Often indeed, price tends to re-bounce nearby these zones.
5. Central Value for Envelops and Bollinger Bands
Moving averages constitute central values around which Envelops and Bollinger Bands are build.
These overlays indicators, extremely popular, are used to gauge relative levels of price overextension in the market: they catch volatility in the market.
Personally, I don’t use methods for price containment during my trading activity. Nevertheless, they are extremely popular, so I think is important to mention this characteristic among the most important uses of moving averages.
6. Triggers for Enter in a New Trade: moving averages crossovers
This is by far one of the best uses of moving averages. We’ve said that whenever there’s a cross, we might expect a change in the market. That’s completely true, and we can use moving averages to generate signals of entry in the market.
Triggers for enter in a new trade may be provided by crossovers between:
- Price and moving average;
- Two or more moving averages;
- A moving average and its smoothed version.
Among these, the first trigger is by far the most important of the three, since represents a price action confirmation about a change in the underlying trend.
The other two instead, are used only for add evidences that a change has actually occurred in market.
The exact point of entry in the market depends on your trading plan, and should be based upon a statistical backtesting of your strategies. I made an article about when to enter a trade in the forex and stock markets, I suggest you to read it if you want to sharper your entrances in the market.
What We Have Learned Today
You should now have a complete understanding of what are the main uses of moving averages and what are the main characteristics of these powerful indicators.
I hope you enjoyed this content! Feel free to leave a comment if you wish. Good luck for your trading!