How to Use Moving Averages Effectively

A popular way of identifying trends is using moving averages. A moving average is a line on a chart that smoothes out price action by calculating an average of closing prices over a period of time and displaying the result on a chart providing an overall direction for a set period.

There are two variables to be determined when using a moving average. You need to decide first on the time period you are going to use to obtain the average and, second, what method of averaging you are going to use.

For example, to calculate a 50-period simple moving average value for any given time, the previous 50 closing prices for that chart periodicity (e.g. hourly, daily etc.) are all added up and divided by 50. The chart below shows a 50-period simple moving average (black line) on a chart of the Euro dollar / US dollar (EURUSD).

The number of periods that make up the time period you use in your moving average should be based on the type of trend you are interested in identifying. Bear in mind that if you are using daily charts, there are only five days per trading week and not seven. So if you are interested in identifying a two-week trend, you may consider using a 10-day simple moving average, rather than 14.

Different Types

Other types of moving averages include exponential and weighted moving averages. These place greater emphasis, or weighting, on more recent data. In contrast, a simple moving average gives equal consideration to all periods used in the calculation. A 40-period exponential moving average will react more quickly to changes in direction in price than a 40-period simple moving average.

Here is a chart of those two moving averages plotted.

You will notice that the exponential moving average was the first to change direction when the price did.

One of the commonly held views on the disadvantages of using moving averages is that they lag behind the price, therefore indicating the trend (or change in trend) too late, or once the price has already started to move in a particular direction. By definition, moving averages have no choice.

Therefore, some people prefer to use exponential or weighted moving averages rather than simple moving averages, as those moving averages do react faster to changes in price direction. The mathematics behind their calculation ensures this.

However I don’t give much credence to such a view, for one reason. For any exponential or weighted moving average you can find, I will be able to find a very similar simple moving average line — it will just use a different number for the time period, however practically it will be an almost identical line.

Here is an example using the GBPUSD:

Despite the two lines being mathematically different, I would argue that based on the practical application of moving averages, there isn’t any difference between them.

Multiple Moving Averages

Another very popular use of moving averages is to use multiple moving averages on a chart representing different trend time frames.

Below is a daily chart of the US30 index with a 13-day (short-term), a 55-day (medium-term) and a 150-day (long-term) simple moving averages attached. Using two or three moving averages of different time frames can give you a broader assessment of the index direction.

In this chart, you will see that the shorter moving average (one that uses a smaller number of days in its calculation – i.e. 13) is more sensitive to the current price and will therefore always stay closer to the price than a longer moving average. You will note that the 13-day moving average on the chart is the line that most closely mirrors the index movement. The line furthest away from the price is the 150-day moving average.

One item to consider when assessing the strength of the trend when using multiple moving averages is whether two moving averages are moving towards each other or moving closer together.

For example, in the chart above of the US30 index, in the second half of the chart you will see the red moving average moving further away from the blue moving average (i.e. the difference between them is increasing), which demonstrates how strong the current trend is.

Something to be mindful of when using moving averages is that the smaller number you use, the less effective moving averages tend to be.

For example, look at the chart of the EURUSD below:

On this chart is a 1 period simple moving average (in black) and a 3-period simple moving average (dark blue). You could make a strong argument that those two lines are providing little value to you as a trader.

What are they actually indicating to you?

At least if you use larger numbers in your moving average, for example 5 or greater, you can assess a type of trend.

Lagging Can Be Good

Again, one of the main criticisms of moving averages is that they are lagging indicators. However, this can be advantage.

For some traders, they don’t attempt to identify reversals in price, they look to trade in well-established trends, so any delay in indicating the new trend doesn’t affect them. Therefore, a moving average needs more convincing that price has actually changed direction before it changes direction too.

In other words, just because price has moved two or three candlesticks against the trend, the moving average is not going to bite and change direction until there is more data supporting the change in direction. This can be an advantage.

Application

There are several ways to use moving averages in your trading, and I believe the simplest is to note the recent direction of the indicator and where the price is in relationship to the moving average.

For example, for an uptrend you want to see the moving average at the right-hand edge of the chart heading in a clear upwards direction. Plus, you want to see the present price above the moving average. Both conditions need to be in place for an uptrend.

The opposite is true for a downtrend. The moving average needs to be moving down and the price needs to be below the moving average.

Based on this, you also would prefer to see the moving average line being quite steep indicating how strong the trend is. Conversely a flatter moving average line indicates a weaker trend.

For trend followers, this is not what you want to see, as you want the moving average to be heading in a clear direction — either up or down.

Finally

Moving averages are a very simple indicator however can be very effective, especially for those traders interested in trading with trend.

Whilst they have inherent weaknesses, if used correctly, they can provide an objective assessment of trend and help traders trade with the trend more often.