Moving Average is one of the most simple tool you can use in your journey of trading and also investing.
“Trend is your Friend.”
This is a quotes carried by many traders.
If trend is the best friend of trader, then Moving Average is the tool to find your friend (trend).
The Tool is mean by averaging the moving changes of the data (price).
Just like giving a center line to a road, guiding us.
it is easy to use.
Some of the trader can profit by only using this tool. If you are a new trader, I encourage you to add in this tool in your trading system if you haven’t yet.
Before we get into how to use the Moving Average, we will first look at the common variations of Moving average and method of calculation.
If you want to know more about trend, click here to my other post.
SO now lets get started…
The Moving Average Method Definition
In Moving Average Method, We are using Moving Average Line for determine the trend movement.
But how the lines form??
Actually it is very simple.
Moving average line is formed by linking every single point of averaged price together.
There are various ways to form the Moving Average Line due to different forms of Moving Average.
Different Forms of Moving Average Method
Two of the popular Moving Average are the Simple Moving Average (SMA) and Exponential Moving Average (EMA).
Simple Moving Average (SMA)
The formula for forming SMA is by adding up certain period prices together and divide by the numbers of period. e.g.:
Average point1 = (Price1 + Price2 + Price3 +…+ Price n) / ( n )
Average point2 = (Price2 + Price3 + Price4 +…+ Price n) / ( n )
… and so on.
*n = the number of Period
By linking each of the point, it will give you the SMA Line (the red line under the candles) as shown in the previous diagram.
Exponential Moving Average (EMA)
For the formula of EMA is:
Current EMA = ((Current Price – Previous EMA) X K) + previous EMA.
The factor ‘K’ is = 2/(1+n).
*n = the number of periods.
By linking each of the point, it will give you the EMA Line (the white line under the candles) as shown in the diagram above.
So…what is the different of these two?
Look at the diagram below.
White line shown in the diagram is the EMA-30 period; Red line shown in the diagram is the SMA-30 period.
Exponential Moving Average tend to have faster reaction than the normal SMA, it also tend to be plot nearer to the price. Hence, it is more sensitive to the price reaction.
Personally I encourage new trader to try out on using EMA.
It gives you a quicker reaction to the market.
Other Types of Moving Average
SMA and EMA are the most common type of Moving Average, but there are still many types of moving average to choose to suit your trading system.
The other types of moving average are Time Series Moving Average, Triangular Moving Average, Weighted Moving Average and Many more.
How to Read and Use The Moving Average
Use to Identifying The Trend
Okay, after the explanation of basic calculation of SMA and EMA, let’s get to the most important part. (It doesn’t matter if you didn’t really understand how to calculate the Moving Average.)
The function of moving average is to indicate the formation of trend, either the bullish or bearish trend.
When the price is moving above the Moving Average Line that’s mean the trend is currently bullish; if it’s below the Moving Average line, then the trend is bearish.
Use to Identifying The Retrenchment of The Trend
The Moving Average method not only can help you to identify trend, it also can help you determine the Support of the trend.
It is useful when you want to wait for the price to retrench or reverse.
Other time, it also can guide you to set your stop-loss of the entry trades.
Periods of Moving Average
The smaller the period in the Moving average, the more sensitive it tend to be in identifying the trend.
If the moving average is too sensitive to the price movement, it will produce a “false-alarm” to you when you want to enter a trade.
Let’s look at the diagram below.
*Although there are other ways to analyze diagram above about determine the trend, but at here, I’m just showing how to use Moving Average as the only tool.*
In the other hand, when the moving average is not that sensitive, you will tend to missed the good opportunity to enter a trade.
So, your sensitivity of your Moving Average need to suit to your trading system to help you to get a good result.
When you use a larger period of the Moving Average, it will help to show you a larger trend movement, reversely, a smaller period of Moving Average shows the smaller trend.
Using Multiple Period of Moving Average
For more confirmation on identifying a trend and support, it is better when using multiple Moving Average with different period.
E.g. when the price is breaking your initial moving average you may want to wait for the smaller period Moving Average line break your larger period Moving Average line.
The crossing of the different period’s moving average line is acting as the confirmation of the trend.
In the diagram we can identify the crossing of two Moving Average line. The first two circled is the crossing of the Moving Average line when the price trend up.
In the third circled location, we can notice that the price cross over the White Moving Average but the Cyan Moving Average did not cross over the White Moving Average.
Thus, the confirmation on the trending up of the price is failed.
Moving Average Not The Holy Grail
The Moving Average will not work all the time. Even when we implement multiple Moving Average.
In the diagram, the Moving Average cross over each other but the price just going down for a short period of the time and continue ride up.
We do not need the Moving Average to work 100% all the time to profit from the market.
Not any method can give us 100% of the winning chances.
To increase the win-rate of our trading system, we can implement other tools to help us on our trading system. E.g. trend-line, types of indicator and oscillator.
Moving Average is a great tool to identify trend for new traders.
It is easy to use and not complicated at all (as long as you didn’t use too much of Moving Average line and confusing yourself).
Personally, I would like to suggest new trader to use two or three different periods (two or three lines) of EMA in your trading strategy.
Remember, waiting for the crossing of two different period of Moving Average Lines is better to confirm a formation of a trend.
To choose the period for Moving Average, you need to know sensitive you want it to be. When it is sensitive enough, you can react faster to the market. In the meantime, there will be many false alarm appear when it is too sensitive.
You should try and adjust the period of Moving Average you used until it can meet the balance between the sensitivity and the appearance of false signal.
Thanks for spending your precious time together.
Let us grow and learn together.