Moving average is one of the most commonly used technical indicators for trading bitcoin and other financial instruments. If you’ve spent even a little time looking at price charts, you will have noticed that most often the price of an instrument will move up and down. In fast moving markets, you may find that the price may be surging up only to plummet moments later, before surging up again, increasing the potential for false signals.
The moving average can help filter out the noise from random price movements and smooth it out in order to see the average value. Moving averages are used to identify trends and confirm reversals. When the price is above the moving average line, we consider the instrument to be in an uptrend. Conversely, if the price is below the moving average line, we consider it to be in a downtrend. The breaking of the moving average line usually implies a trend reversal.
Moving averages are also used to identify areas of support and resistance. Many traders will consider the moving average line as a support and resistance level indicator and base trades on it. So traders will check to see whether the price is going towards the moving average, and see whether it will bounce back from it or break it, as with regular support or a resistance level. Often times the price of an instrument will find support at the moving average line when the trend is up and will find resistance at the moving average line when the trend is down.
Moving averages will tell you whether an instrument is trending up, down or if it’s ranging. It can tell you if a trend is still in motion and whether it is reversing or losing momentum. Have in mind, that a moving average is based on past prices and is known as a lagging indicator. Therefore, it will not warn you in advance but it will confirm when a trend change has taken place.
At the most basic level, when the price crosses up and over the moving average, traders take this as a signal to buy. Once it crosses down under the moving average line, they consider it a signal to sell.
Understanding Moving Averages for Trading
Types of Moving Averages
- Simple Moving Average (SMA)
- Weighted Moving Average (WMA)
- Exponential Moving Average (EMA)
We will discuss the simple moving average or SMA first and show you how it’s calculated, so that you can adjust it according to the given market circumstance.
So if you wanted to plot a 10 day simple moving average, you would add the closing prices of the last 10 days and divide by 10. This calculation gives equal weight to each day and it’s called a moving average as the oldest price is dropped each time a new period becomes available. In this way insuring that the average is based only on the last X number of periods, in our example for the last ten days.
Have in mind that the longer the simple moving average period, the more it lags and the slower it is to react to the most recent price movement. And this brings us to its downside, as equal weight is given to all periods considered in the calculation, the simple moving average is slower to respond to rapid price changes that might prove to be important.
So how can you counter this? With another type of moving average, either a weighted or an exponential moving average.
The weighted and exponential moving averages are calculated differently from one another but both types give more weight to recent periods and thus more emphasis on what traders are doing at the moment. So as a result, weighted and exponential moving averages respond faster to price action by distributing more weight to recent periods and less to older periods. They reflect a quicker shift in sentiment, which can be due to changes in supply and demand, or important news events that impact the traded instrument.
To illustrate what we mean, if you were to plot an exponential moving average and a simple moving average on a chart, you will see that the exponential moving average is closer to the current price than the simple moving average.
Moving Average Time Periods
Apart from the type of moving average, you also have to decide on the time period. This will largely depend on the type of trend you are analyzing. Here are some guidelines for commonly used time periods:
- 10 to 20 days for short-term trends
- 50 days for midterm-term trends
- 200 days for long-term trends
When and how should you use moving averages?
Deciding which moving average to use and the time period will depend largely on your objective. Use exponential moving averages for shorter time frames or if you’re analyzing a fast moving market, as you’d have more emphasis on the latest prices.
Use simple moving averages if you’re planning on holding a position for a longer period of time, as the exponential moving average might be too sensitive and give false signals. You should also use simple moving averages if you just like to filter out the noise and random price fluctuations to determine the overall market direction.
How to Trade Using Moving Average Crossovers
Let’s get into how to use moving averages to identify the direction of a trend, how they can be used to enter or exit a trade and finally how to trade moving average crossovers. To determine the direction of a trend using a moving average, you must take into account the set time period.
Why is it important to be aware of the time period of the moving average? In this chart, we place a 20 days time period simple moving average by clicking the indicator icon and setting the time period to 20. We can clearly see that it indicates an uptrend. Yet, when we place a 60 days time period simple moving average in the same way, we see that it shows the price in a range with no clear upward or downward trend.
The difference in the direction of the trend portrayed by the moving average is due to the time period. Shorter time period moving averages are faster at generating signals and changes in the price of the trading instrument will be reflected more quickly. The longer time period moving average will react to price changes much more slowly but will generally provide more reliable trading signals.
As a trader, moving averages will help you decide which way to trade by looking at whether the price is above or below the moving average line. In this chart the price is above the moving average line and acts as support. You could buy and enter a long position when the price pulls back to the moving average line, you could then place your stop-loss underneath the moving average.
Here we can see the opposite. The price is below the moving average and acts as resistance. You could then enter a sell order when the price retraces to the moving average line and place your stop-loss above the moving average.
Moving Average Crossovers
The interesting thing about moving averages is that they can be used alone or in combination with other moving averages. When you place two moving averages on one chart with different time periods, reflecting a short-term and a longer-term trend in price, you have the opportunity to trade moving average crossovers. They can be used to determine when a trend has changed direction.
Let’s show you what we mean on a daily chart for the GBP (British Pound) and USD (US Dollar). We will now place a 10 days time period simple moving average and a 20 days time period simple moving average. When a short term moving average crosses above a longer term moving average, you can signal that the trend is changing direction to the upside and it may be a good time to buy. When a shorter period moving average crosses below a longer period moving average, this is considered bearish, a signal that the trend may be changing towards the downside and it may be a good time to sell. No matter which two time periods you use, this principle will remain the same.
To recap, a moving average is a lagging indicator that can help filter out the noise from random price movements to see the average value. It can help identify the trend direction, determine support and resistance levels and can help confirm a trend reversal when looking at moving average crossovers. It is important to understand the differences between the types of moving averages, and how to tailor the time period to best fit the trend being followed in order to gain the maximum benefit from this technical trading indicator.