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In order to use Moving Averages as a trade signals you first must understand what a Moving Average is.
Moving averages smooth price data to help identify the current trend. Moving averages are a lagging indicator, as they are based on historical prices. We use them because trends do not move smoothly in one direction...price tends to chop around in the short term but will follow a trend in the longer term. Moving averages help to smooth the price action over time and therefore help to more clearly identify the longer term trend.
The two most popular types of moving averages are the Simple Moving Average (SMA) and the Exponential Moving Average (EMA) but other examples you may hear about are: adaptive, centered, volume adjusted, weighted etc. I only follow the simple moving average but will examine the two most popular, to help you decide which may work for you.
The two most common calculations of moving averages.
A simple moving average is calculated by taking a period of closing prices & adding them together then dividing them by the number of closing prices you have. So a 10 day MA takes the last 10 days closing prices. Add them up and divide by 10. You now have the first value for your 10 day moving average. The next day you add the new closing value, deduct the first closing value from the day before and again, divide by 10. Simple!
A 10 day moving average will therefore change more dramatically because it is more sensitive to short term price movement than a 100 day moving average. Both are lagging indicators but the longer term moving averages react much more slowly to price change.
Exponential moving averages differ because they apply more weight to the more recent prices in the calculation. The idea is to make this moving average more sensitive to recent price changes. Exponential moving averages will turn before simple moving averages when prices changes direction.
I stated above that I only use simple moving averages. Why? To me they represent a true average of prices for the entire time period so I believe they are better suited to identify support and resistance levels. I primarily use the value of the moving average as a support or resistance level. I also focus on the 55, 100 & 200 period moving averages as I believe they offer the most reliable levels – whether that period be a monthly, weekly, daily or hourly chart.
However bear in mind that I do need a ‘one –size-fits-all’ approach to my technical analysis. This is because I provide daily technical analysis to professional traders on up to 25 markets each morning. I do not have the time to perfectly fit each moving average for each time period for each market. If you only trade one or two markets, it could be worth experimenting with different time periods to see if you can find ones that better suit those markets and therefore provide more reliable support & resistance levels.
The length of the moving average that you should follow depends on your trading style. A day trader looking at a daily chart is likely to be more focused on short term moving averages eg. 5-25 day. Long-term traders/ investors, such as the hedge and pension fund managers mentioned previously, will prefer longer term moving averages such as 100 & 200 day moving averages.
A moving average ‘cross over’ is used as a trade signal.
This is one of the main reasons for using more than one moving average. The longer moving average is used to identify the longer term trend and the shorter moving average is used to generate the signals.
A. A bullish signal is first generated when prices move above or below the moving average. The example below shows the bottoming out of the Emini S&P after the 2008 financial crisis. Were there any clear buy signals to tell us the market had bottomed?
The first signal was generated when the price of the Emini S&P crossed over above the 55 day moving average (purple line) which was already flattening out, indicating that the bear trend may be ending.
Confirmation of this buy signal was generated when price crossed above the 100 day moving average (black line), which was also flattening out, indicating that the longer term bear trend may be ending.
The market is now clearly in a short term bull trend. If you had begun buying on the first price cross over and added to your investment on the second cross over you would be looking at healthy profits going forward.
As long as price holds above the moving averages, the investor is feeling confident. You can see that it did not take too long for the moving averages to confirm the positive trend as they started to turn upwards. Even after such a dramatic crash in 2008, both moving averages had turned higher within 2-3 months of a bottom being established.
However the key bullish ‘buy’ signal is generated when the faster 55 day moving average crosses and holds above the slower 100 day moving average. This is further confirmation that a bullish trend is being established. This is called a ‘Golden Cross’ when a fast moving average crosses above a slow moving average. Ideally both moving averages should be at least starting to turn higher as they cross for the best signal.
The only problem with waiting for this key signal and not acting on the price cross over signal is that you miss a big part of the initial move. This part can often be the fastest part of the recovery as short positions are ‘squeezed’ or forced to exit through stop loss orders being triggered.
However the more confirmation you wait for the lower the risk as the trend is clearer. There is always a trade off! One strategy is to drip feed funds in to the position as more positive signals are generated and average in to the rising market. This ensures not all eggs are in one basket at the riskiest moment. You only know the market has turned after a significant period of rising prices!
You can see how the 55 day moving average did a good job most of the time, in providing support when the market hit some short term profit taking. When this level failed however the 100 day moving average worked as the next support, confirming that the market remains in a positive trend. The price crossing below the 55 day moving average was not a negative signal because the moving averages are clearly pointing higher and the price never broke the 100 day moving average support area.
These indicators will help you to remain confident in your investment.
B. A bearish (negative) signal is generated when prices move below the moving average.
This chart above shows the Emini S&P in a topping process after a four and a half year bull market run from 2003 to 2007. Initially the market enters a sideways but very volatile trend. Note that bull markets tend to end with very volatile conditions such as the example here as bulls & bears battle it out for control. Bear markets tend to end much more quickly with a ‘V’ shaped turn in the market.
The moving averages and also the price cross above and below for a period of time to indicate the sideways trend. Eventually the 55 day moving average and the price holds below the 100 day moving average and at that stage the market collapses and in fact crashed very sharply.
This was only the beginning. There was some confusion about half way through the crash as the price made a break above the moving averages & the 55 day moving average crossed back above the 100 day moving average.
However the 100 day moving average continued to point lower throughout this period. It was not long before price collapsed again & held below both moving averages in a negative signal. This was confirmed with the 55 day moving average crossing back below the 100 day moving average. The 55 day moving average continued to do it’s job well as a strong resistance level on any bounce and the market crashed again. The moving averages continued to point lower throughout this crash to confirm the bear trend.
When a fast moving average crosses & holds below a slow moving average this is called a ‘Dead Cross’. Again, like the ‘Golden Cross’, it is a stronger signal when both moving averages are starting to point lower when they cross.
C. A triple crossover involves three moving averages as you may have guessed. Again, a signal is generated when the shortest moving average crosses the two longer moving averages. I imagine there is no end to the number of moving average crossovers you could employ but 2 should be enough!
Moving average crossovers produce late signals because they are lagging indicators. The longer the moving average periods, the greater the lag in the signals. A moving average crossover system will therefore produce lots of whipsaws in the absence of a strong trend. This is clearly demonstrated with the last example above when the four and a half year bull trend ends at the time of the start of the financial crisis in 2008. The moving averages whipsawed until finally the bear trend became established.
For this reason I do not pay must attention to 100 & 200 moving average crossovers, I only watch the 55 & 100. Often by the time the longer term lagging indicators cross, the move has actually ended!
You may wish to experiment with short term moving averages on the markets you trade to see if you can find reliable cross over time periods to follow.
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Written by Jason Sen of Day Trade Ideas