In this module of “Technical Analysis demystified” we look at the various types of moving averages and how the signals generated can be used by traders.
What are Moving Averages?
In technical analysis, a Moving Average is a trend-following technical indicator. It never anticipates, only reacts to the stock market trend. Technical analysts use it is a smoothing device for the raw price action. It is used among professional traders including CTAs and it there are famous books including on the Turtle Traders about how it has improved hedge fund performance.
Many stock and forex traders rely heavily on 50 and 200-day Moving Averages in the medium-term. For longer term, they use 30 week and 40 week Moving Averages on their price charts. However, moving averages are a popular technical analysis tool in many markets, including gold metal markets. Future gold demand can often be forecasted by analysing moving averages.
Different types of MA in technical analysis
A Simple Moving Average is basically an arithmetic mean. It gives equal weight to each day’s price.
A Linearly Weighted Moving Average is calculated in the following way: the closing price of the 10th day will be multiplied by 10, the 9th day by 9, etc…The total is then divided by the sum of multiples.
An Exponentially Smoothed Moving Average assigns greater weight to the more recent data and this include all the data in the life of the contract. Typically, it assigns a 5 value to the last day’s price.
NB: The practical difference between an exponential moving average and a simple moving average is minimal. But the exponential moving average is consistently closer to the actual price.
The Adaptive Moving Average is based on an Efficient ratio (ER) equals to the Price direction divided by the level of risk.
If ER is high, the average is faster.
If ER is low, the average is slower.
How to use Moving averages
Below we highlight three technical analysis trading strategies that using moving averages to help determine future price movements.
1. Moving Average crossover trading Strategy
A BUY signal is triggered when the closing price is above the Moving Average. For added confirmation, the Moving Average must turn itself in the direction of the price trend.
Under the double crossover method (or golden cross), the shorter moving average must be above the longer average (i.e. it crosses above). This lags a bit more than single Buy signal.
Traders can also use 3 averages (4 > 9 > 18). They will BUY when 4 crosses above 9 AND 18. A confirmation takes place when 9 days moving average is above the 18 days moving average. The technique can be used on any timeframe, including using hourly chart price action.
When 3 Moving Average of relatively different time span converge, it indicates that:
- The balance between buyers & sellers is evenly matched
- The price is set up ready for a relatively large move in either direction
2. Moving Averages band channels
Also called channels, moving average bands can be created in many ways:
- A fixed percentage above and below the average (e.g. 3% around a single 21-day MA)
- An absolute point value
- A volatility function
3. Moving Averages envelopes
A simple moving average line can be enhanced by surrounding the line pattern with parallel envelopes. These envelopes deviate from the moving average line by a user-specified percentage in order to determine when prices have strayed from the moving average line by that percentage.
For example, charting 3% envelopes would display an upper parallel line that is 3% above the Moving Average line, and a lower parallel line that is 3% below the Moving Average line.
Moves outside of the 3% envelopes are significant for short term traders who are more concerned with smaller price fluctuations. When on one price band, traders can use the opposite band as a price target.
Chart analysis, technical analysis and other means of analysing a price chart can be greatly enhanced by the careful use of moving averages, including the above 3 moving average trading strategies.