Moving average: definition, explanation and examples

The moving average (MA) is a key tool in technical analysis used to identify trends in financial markets. By smoothing price movements, it helps traders better understand market signals and make informed trading decisions. Whether you want to determine the long-term direction of a trend or use short-term signals for entry and exit points, the moving average offers a range of applications.

We explain what a moving average is, how it is calculated, and how you can effectively integrate it into your trading strategies.

• A moving average smooths price movements and helps identify trends in financial markets

• The calculation formula allows for the determination of the simple moving average (SMA) and the exponential moving average (EMA)

• Strategies such as the crossover strategy, the ribbon strategy, or the Bollinger Bands strategy use the moving average to generate buy and sell signals

• Despite its versatility, the moving average should always be combined with other indicators, as it is based on historical data and reacts to market movements with a delay

Definition: what is a moving average?

A moving average is a statistical method used to smooth data series over a specific period. It is particularly useful in technical analysis, as it helps identify trends and filter out short-term price fluctuations. By calculating an average value from a set number of data points, it creates a dynamic line that updates with each new value.

This tool is often used to determine the overall market direction and to identify key signals such as buy or sell points. It provides a clearer overview of price movements, helping investors make better-informed decisions. Moving averages are easy to use and form a valuable basis for well-founded market analysis.

Types of moving averages

There are various types of moving averages, mainly differing in their calculation methods. The two most common types are the simple moving average (SMA) and the exponential moving average (EMA). Both are used to analyse price movements, and each has specific advantages and disadvantages, which can be leveraged depending on the trading strategy.

Simple moving average

The simple moving average (SMA) is the most basic form of a moving average. It is calculated by taking the average closing price over a set number of days or periods. For example, a 10-day SMA is the mean of the last ten closing prices. As a new closing price is added, the oldest one is removed from the calculation, keeping the line dynamic.

This method is particularly popular among beginners, as it is easy to calculate and understand. The SMA helps identify the overall trend direction and is often used as a foundation for buy or sell signals, especially when combined with other indicators. However, the SMA reacts more slowly to sudden price changes, as all data points are weighted equally.

Exponential moving average

The exponential moving average (EMA) places greater weight on recent price movements. This is achieved by applying a weighting factor that gives more significance to recent data points. As a result, the EMA is more sensitive to short-term changes, making it particularly useful for traders looking to capitalise on fast market movements.

One advantage of the EMA is its ability to detect current trends more quickly, making it appealing for short-term trading strategies and volatile markets. However, its higher sensitivity can also lead to more frequent reactions to short-term fluctuations, which are not always relevant.

Moving average – an example

A practical example of a moving average is a 10-day SMA (Simple Moving Average). Suppose the closing prices over the last ten trading days were £100, £102, £101, £103, £105, £107, £108, £110, £109, and £111.

The simple moving average is calculated by summing these values and dividing by the number of days (10). In this case, the SMA equals £105.60.

This value represents the average closing price over the past ten days and indicates the general trend direction. With each new trading day, the oldest closing price is removed, and the latest one is added, ensuring that the moving average remains up to date. On a price chart, this value is displayed as a line that smooths price movements and reduces fluctuations.

In practice, a trader could use this SMA to determine whether the current price is above or below the average:

• If the price is above the moving average, this often indicates an uptrend

• If it is below the moving average, this could suggest a downtrend

Why choose a 10-day SMA instead of a 50- or 200-day SMA?

The choice of period depends on the trading strategy:

• Short-term traders use 10- to 20-day SMAs to get quick signals for short-term market movements

• Swing traders (who hold positions for several days to weeks) use 50-day SMAs to identify mid-term trends

• Long-term investors prefer 100- or 200-day SMAs to detect large market trends and make long-term decisions

Depending on the strategy, a shorter or longer period may be more suitable.

How to calculate the moving average

Calculating a moving average is straightforward and can be done in different ways, depending on whether you want to use a simple moving average (SMA) or an exponential moving average (EMA). Below are the calculation methods for both:

Simple moving average (SMA)

1. Collect data: Record the closing prices over the desired number of days (e.g. 10 days)

2. Sum the values: Add up the closing prices for the selected period

3. Calculate the average: Divide the sum by the number of days

Example:
For a 10-day SMA with closing prices of £100, £102, £101, £103, £105, £107, £108, £110, £109, and £111, the calculation is:

• Sum: £1,056

• SMA: £105.60

Exponential moving average (EMA)

The EMA places more emphasis on recent price movements and is slightly more complex:

1. Calculate the starting point: Use the SMA as the base value for the first EMA calculation

2. Determine the weighting factor: The factor is calculated using the formula:

   • Weighting factor = 2 / (number of periods + 1)

   • For a 10-day EMA, the factor is 0.1818

3. Calculate the EMA using the formula:

   • EMA = (current price - previous day's EMA) × weighting factor + previous day's EMA

Trading strategies with moving averages

The moving average, also known as the moving mean, is a key tool in technical analysis, particularly in markets with high price fluctuations, such as the cryptocurrency market. Cryptocurrencies are known for their high volatility, meaning prices often move quickly and dramatically. The moving average helps to make trends more visible and provides clear signals for buy and sell decisions.

However, despite its versatility, the moving average also has limitations. Since it is based on historical data, it responds slowly to sudden market movements. This can result in delayed signals or false signals, particularly in volatile or sideways markets.

Traders should therefore not rely on the moving average alone but combine it with other trading indicators to make more informed decisions. The following strategies demonstrate how the moving average can be effectively used to analyse market trends and identify potential buy and sell signals.

Ribbon strategy

The ribbon strategy combines multiple moving averages of different period lengths to analyse the strength of a trend and identify potential turning points. These moving averages, such as a 10-day, 20-day, and 50-day SMA, run parallel and form a visual "ribbon" on the price chart.

A key advantage of the ribbon strategy is that it clearly visualises market dynamics:

• When the moving averages are close together, this indicates low volatility

• When they spread apart, this suggests strong trends

However, the strategy can produce false signals in sideways markets, as the moving averages frequently cross over, making it difficult to determine a clear direction. Beginners should therefore use additional indicators to confirm the signals generated by the ribbon strategy.

Crossover strategy

The crossover strategy is one of the most well-known methods for using moving averages in trading. It involves combining two moving averages with different period lengths, such as a 50-day and a 200-day SMA.

• Golden cross: When a short-term moving average crosses above a long-term moving average, this is called a golden cross. It is considered a bullish signal, indicating that an uptrend may be emerging.

• Death cross: When the short-term moving average crosses below the long-term moving average, this is known as a death cross. It signals a potential downtrend, suggesting that the short-term momentum is weakening.

A major advantage of this strategy is its simplicity and clarity, making it especially suitable for beginners. However, a key drawback is that signals often arrive late, since moving averages rely on historical data. This can cause traders to enter trends too late or miss signals during rapid price changes.

MACD strategy

The moving average convergence divergence (MACD) combines moving averages with momentum indicators to assess both trends and their strength. The MACD consists of two lines:

• The MACD line, which measures the difference between two EMAs

• The signal line, which is a 9-day EMA of the MACD

When these lines cross, they generate buy or sell signals.

The advantage of the MACD strategy is that it blends moving averages with momentum, making it versatile and effective. In strong trends, the MACD provides reliable signals. However, in sideways markets, its effectiveness diminishes, and it can generate false signals.

To improve accuracy, traders should combine the MACD with other indicators to better assess the market situation.

Bollinger bands strategy

The Bollinger bands strategy combines a moving average (typically a 20-day SMA) with volatility bands, which are determined by the standard deviation of price movements. These upper and lower bands help identify overbought or oversold market conditions.

• If prices approach the upper band, the market may be overbought

• If prices approach the lower band, the market may be oversold

A key advantage of this strategy is that it accounts for both trends and market volatility. Traders can identify potential reversal points when prices deviate too far from the moving average.

However, in strong trending markets, this strategy is less reliable, as prices can remain near the upper or lower bands for an extended period without reversing.

Conclusion: technical analysis with moving averages

Moving averages are a valuable tool in technical analysis. They help smooth price fluctuations and reveal trends that might otherwise be hidden in daily market movements. With simple formulas, you can calculate the moving average and integrate it directly into your analysis. They are particularly useful for identifying buy or sell signals and making informed trading decisions.

One of the key advantages of the moving average is its versatility. Whether using a simple moving average (SMA) or an exponential moving average (EMA), both can be flexibly integrated into strategies such as the crossover strategy or the Bollinger bands strategy. They help traders identify trends, spot support and resistance levels, and optimise trading strategies.

However, traders should also be aware of the limitations of moving averages. Since they are based on historical data, they often react slowly to sudden price changes. In volatile markets, this can lead to delayed or inaccurate signals. To compensate for this, it is advisable to combine moving averages with other indicators, such as the MACD or volatility analysis, to gain a more comprehensive market view.

In summary: The moving average is a simple yet effective indicator that benefits both beginners and experienced traders. With the right tools and a well-thought-out strategy, you can use it to identify bullish trends or bearish markets and make better trading decisions based on thorough analysis.

Further topics on trading

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