- The moving average is a calculation of the average price that an asset is trading at over a set period.
- For example, if we are looking at a daily Bitcoin chart with the 20 MA applied, we are going to see what the average price is over the last 20 periods, i.e., the previous 20 days.
For the sake of this article, we are going to keep this simple. To truly develop an edge using moving averages, a trader should backtest as much as possible.
What are Moving Averages?
One of the most popular indicators across all markets is the Moving Average. The moving average is exactly what its name implies, a calculation of the average price that an asset is trading at over a set period. This can be in the form of a basic “Moving Average”, which is just an arithmetic mean; or an “Exponential Moving Average”, which assigns more weighting to the most recent prices.
For the sake of this article, we are going to stick with the basic Moving Average, otherwise referred to as a “Simple Moving Average”. For example, if we are looking at a daily Bitcoin chart with the 20 MA applied, we are going to see what the average price is over the last 20 periods, i.e., the previous 20 days. Hence the idea of a simple arithmetic mean- we are taking the candle closing prices of the last 20 days and dividing them by 20 to get an average.
It is important to note that we are looking at a moving average in terms of “periods”. So, if we are looking at the 20 MA on the daily, we are seeing the average of the last 20 day closes; however, if we look at the 20 MA on the 5-minute chart, we are seeing the average price of the last 20 5-minute periods.
The most common moving average lengths are the 9, 20, 50, 100, and 200. The lower periods are referred to as the faster periods, while the higher periods are referred to as the slower periods. These are also referred to as “look back periods”. It is essential to understand that all of these periods are lagging.
Trend trading with Moving Averages
Moving averages are great tools for trading trending markets. They can be combined with either different variations of themselves or other indicators to develop systematic and discretionary strategies.
Here are some great ways in which moving averages can be used:
Use Moving Averages to smooth out and determine the general direction of a trend–
When the moving averages are pointing or sloped upward this indicates that the underlying price action is currently moving in an upward trend. For some people, this takes out the subjectivity of paying attention to price action. For example, below, if we look at a daily chart and apply something like a 20-period moving average, we can clearly see that the trend is north over time.
We can also note some important details about the strength of the trend regarding how extended price is from the moving averages and the periods in which the moving averages go from being more sharply pointed upward vs. beginning to taper off and slant back downward. These details can help us determine whether the trend is heating up or cooling down. For example, if we see that price is beginning to return to the moving average (the 20 in this case), we can say the trend may be cooling off or approaching what will maybe be a period of consolidation.
We can also see a possible change in the trend if the price begins to fall under the moving average or if the moving average begins to turn back downward. Again, this is a lagging indicator, so it is only showing us what price is already doing, but it does help to make it a bit more obvious, although slightly late to signal.
We can sharpen the idea presented above by applying more than one moving average and watching for crossovers or cases where the moving averages are diverging or converging. In the example below, we have a daily chart with the 20 MA in red and 50 MA in blue. For a trend follower, using moving averages can keep them in the trend for much of the move. In most cases, this involves using a combination of faster and slower period moving averages to identify the shift in the short term vs. long term price action.
Notice how there were periods where the moving averages compressed during the consolidations; however, they did not cross. During these periods of compression, traders may look at adding to positions, so long as the moving averages maintain their position to each other. The trend shows signs of changing when we see the moving averages begin to interact and cross each other physically.
One more way we can use the moving averages is as dynamic supports or resistances. Let’s say we have a powerful trend reversal where price has crossed and is now well extended and above the 20 MA on the daily. One of the better opportunities is to buy a return back to the average. Many times, this area will be systematically bought by traders looking to enter into fast-moving trends. Often, the first retest offers the highest probability of a bounce. Notice in the image below price spends most of its time above the average, and when finally revisiting for the first time, offers a substantial bounce.
The inverse can be expected when the price loses the trend and falls below the moving average with conviction. In the case below, the price loses the 20 MA on the daily, and this line then becomes a dynamic resistance.
This wraps up some of the primary ways we can begin to explore using moving averages. As with all other indicators, these are just “decision support tools” that can be applied independently or with a combination of different forms of price derived feedback. As with all approaches, be sure to backtest as much as possible. The benefit of using moving averages is that you can do this visually in a short amount of time.