Understanding Moving Averages: A Key Tool in Technical Analysis

Simple Moving Average (SMA)

To calculate a SMA, sum up all the prices and divide them by the number of observations. The formula is:

\[
\text{SMA} = \frac{(P1 + P2 + P3 + \dots + Pn)}{n} \\
\]

Where:

  • Pn: The price of the asset at period (n)
  • n: The number of total periods
Chart 1: Simple Moving Average (21-period SMA). Chart: MetaTrader4

Chart 1: Simple Moving Average (21-period SMA). Chart: MetaTrader4

Trading platforms can automatically perform these arithmetic operations and plot the moving average line on the chart. The above example is a 21-period SMA, where each observation represents the weekly closing price.

When the price is below the average, it indicates that bears are controlling the market. Conversely, quotes above the moving average suggest a bull market.

Chart 1 clearly illustrates the strengths and weaknesses of this indicator. It can detect the start of a trend relatively early and, more importantly, smooth out price fluctuations during the trend. For this reason, moving averages are excellent trend-following indicators. However, when prices move sideways, moving averages can generate many false buy and sell signals, as shown in the second part of the chart.

Moving averages are often used in combinations of two or more to capture different time frames. For example, when analyzing a daily chart, it can be helpful to apply the following SMAs:

  • 21-period SMA: Represents about a month of trading.
  • 50-period SMA: Covers more than two months of trading.
  • 200-period SMA: Reflects nearly a year of trading history.

This approach helps identify short-term, medium-term, and long-term trends.

For intraday traders analyzing a one-hour chart, a 24-period average might be attractive. This effectively covers the last twenty-four hours, encompassing all global trading sessions.

Chart 2: SMA 21, 50, 200-period (red, white, blue)

Chart 2: 21, 50 and 200-period SMAs (red, white, blue). Source: MetaTrader4

Chart 2 shows a combination of 21, 50, and 200-day SMAs. The intersection of the slow average (200-period) with the fast ones (21 and 50-period) is crucial, as it may indicate the emergence of a new trend. The substantial EUR/USD decline depicted in Chart 2 has provided several opportunities for sellers.

Such a placement of the averages has confirmatory significance. The faster averages (21 and 50-SMA) are closer to the current prices, and the “fan of averages” has dissolved. The 200-day average lags as older data influence it.

The first signs of ending the decline appear when the 21-SMA crosses above the 50-SMA. At this point, some market participants may start opening long positions, while others may begin exiting their short positions.

It is important to note that many false signals can occur during sideways movements. Opening a position on each break of the 200-day average by the faster MAs during such consolidation periods could lead to a series of losses. Trend-following indicators are not effective when a trend is absent.

However, the benefit of combining multiple averages is also evident. The slow average reflects the primary trend and acts as the last resistance or support line. The fast averages cover shorter periods and respond quickly to price changes.

Simple moving averages are often criticized for not adequately representing the reality of the current market. How relevant is the closing price from two hundred days ago today? Exponential moving averages address this issue by giving more weight to recent observations.

Exponential Moving Average (EMA)

The exponential moving average assigns more weight to recent data, giving traders confidence that current market drivers are appropriately reflected.

Chart 3: SMA vs EMA (21 Weekly SMA (red) and EMA (blue))

Chart 3: SMA vs EMA (21-Weekly SMA (red) and 21-Weekly EMA (blue)). Source: MetaTrader4

Exponential averages have their pros and cons. Compared to SMA, EMAs react faster to market changes and stay closer to recent prices. This is visible in the chart above, which alternates between highs and lows. The sensitivity of exponential averages makes them suitable for traders aiming to catch trends in their very early stages (or exit positions early). However, the quick reaction of EMAs can also generate many false signals.

Chart 4: Multiple EMA (21, 50, 200-day periods). Chart: MetaTrader4

Chart 4: Multiple EMAs – 21, 50, 200-period (red, white, blue). Source: MetaTrader4

In Chart 4, the EMAs are positioned slightly closer to the prices than the SMAs from Chart 2. In this case, there were fewer false signals during the consolidation period, as the 200-day EMA was only broken by the faster ones once or twice at the end of the chart.

Conclusion

Simple Moving Averages and Exponential Moving Averages are widely used trend-following indicators. Sellers tend to open their positions more confidently when prices are below moving averages. Conversely, when prices are above the moving averages, it indicates a favorable opportunity for buyers. Typically, traders use more than one moving average to capture price action over different periods.

Moving averages reveal dynamic support and resistance levels, with each new price changing the MA values. For longer-term traders, the 200-day average is particularly significant as it indicates the underlying trend. The break of this average signals a market reversal.

Simple averages have been criticized for giving equal importance to all observations. Exponential averages address this issue by assigning more weight to recent observations.

In addition to simple and exponential averages, other variations of moving averages are used in technical analysis.

Next: Oscillators

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