Moving averages are one of the most commonly used indicators in technical analysis.
The main objective of moving averages is to identify the primary trend followed by the markets, removing it from very short-term distortions.
The moving average is only the average of a historical series of data.
Whenever new data is added to the series, the oldest information is deleted.
Before describing operational strategies based on the use of moving averages.
Below this point, it is necessary to describe the three most common types of moving averages:
- Simple Moving average
- Weighted Moving Average
- Exponential Moving Average
Simple Moving Average
The simple MA is the easiest to calculate, as it is determined by adding the closing prices of a number n of days and dividing the total result by the number of days.
The flaw of this average is that it attaches equal importance to all prices, both the most recent and the most distant.
The formula for calculating the simple moving average is as follows:
Mobile average Simple at time (t) = (P(t) + P(t-1) + P(t-2) + P(t-3) + …) / n
Weighted Moving Average
The weighted moving average tries to eliminate the main flaw of the simple moving average, as it gives more prominence to new values than to those furthest away in time.
For its determination, more weight is given to the most recent prices, on the assumption that the latter can represent more precisely what is happening on the market.
The calculation of the weighted moving average requires each price to be multiplied by a weight derived from the position of each of the values examined.
For example, for a 5-day average, the first value in the series is multiplied by 1, the second by 2, and so on, up to the last value, which is multiplied by 5.
The total will then be divided by the sum of the weights, in this case 15 (i.e. 1 + 2 + 3 + 4 + 5).
Exponential Moving Average
With the exponential moving average, even more, importance is given to the most recent prices, to link the trend of the average to the short-term movements made by the markets.
cm (multiplication coefficient) = (2/(n + 1))
For a period of 5 periods, for example, the coefficient will be:
(2 /(5 + 1)) = 0.333
The formula for calculating an exponential moving average at time t is as follows:
EMA = EMA(t,-1) + cm × (C-EMA(t,-1)) where:
EMA(t,-1) is the value of the MA exponential to the previous period.
m is the multiplication coefficient.
There is the last closing price.
Moving averages are usually calculated on closing prices and aim to identify trends over the various time horizons.
To capture a short-term trend, for example, a period of 5/8 days can be used; for the medium-term trend, you can use the 20-period average.
For the medium-long term trend, the 50-period and 200-period averages are used.
It should be noted that the choice of the time horizon is a critical element of successfully working with moving averages.
Too short periods expose the trader to the danger of obtaining false operating signals.
Too long periods can instead provide operating signals that are too late compared to market movement.
To obtain information useful for operational purposes, a comparison must be made:
Between moving averages and their previous values. In this case, there can be three different situations:
Trend and Moving Average
The moving average shows a well-defined upward or downward trend and indicates that the market is in a phase of the trend.
The inclination of the moving average indicates the force with which the trend is developing.
An increase in its inclination signals an acceleration of the trend.
A reduction in its inclination indicates that the trend is losing strength.
In this case, the average indicates that the market is in a phase of congestion. Very often, the exit from a lateral phase triggers a movement of particular importance.
In this case, the moving average signals a reversal of trend: from upward to downward or vice versa.
From an operational point of view, it is necessary to highlight that it can be hazardous to open new positions, upwards, or downwards, only because a moving average has changed its direction.
Graphical analysis and other indicators can confirm these signals.
Using two moving averages.
Two moving averages calculated over different time arcs can provide interesting operational signals.
The fast average will always be the closest to prices, indicating the short-term trend followed by quotations.
So if the fastest average (e.g., five periods) is above the slowest average (e.g., 20 periods), the trend is positive. In contrast, the quickest average is below the slowest average; the trend is negative.
On the other hand, the slowest average identifies price behavior over a more extended period.
When the two averages move away, it means that prices are accelerating and that movement in the short term is much faster than in the medium term.
When averages approach each other, however, it means that the market is congested, and there is a phase of substantial equilibrium.
This balance, however, could be transitory, as the consolidation phase could unleash volatility and create the conditions for a directional movement.
Pay attention when the fast average (e.g., 5-period) crosses over the slow average (20-period).
This is the moment when the short-term movement is proving strong enough to exceed the medium-term one.
Moving Averages and Market Price
Moving averages are a useful tool for identifying the primary trend followed by prices.
When prices are above the moving average, the trend is upward.
When prices are below the moving average, the trend is downward.
The moving average also constitutes a dynamic resistance/support for a position trading.
It accompanies the price movement and you can, therefore, use it as a trailing stop.
Moving Average Trading System
MA also provides interesting operational signals.
There is a long signal when prices cross the moving average from bottom to top.
There is a short signal when prices cross the moving average from top to bottom.
For the signal to be reliable, the crossover must be confirmed at the end of the session.
There is an upward signal when the closing price is above the moving average.
There is an upward signal when the closing price falls below the moving average.
An advanced method involves the use of two or more moving averages, usually a fast one and a slow one.
When the fast MA crosses from the bottom up the slower one, we have a long signal.
On the other hand, when the fast-moving average crosses the slowest moving average from top to bottom, we have a short signal.
Moving Average and Market Strength
A technique used by several technical analysts to measure the strength and consistency of the various market movements is based on the study of moving averages.
You have to calculate:
- The number of securities above the 20-period MA.
- Several securities that are above the 50-period MA.
- The number of securities above the 200-period, MA.
The main objective of this methodology is to identify potential overbought and oversold areas that can signal the achievement of essential tops/bottoms on the market and anticipate any reversals of trends.
The same line may indicate the percentage of securities above the 50-period moving average, calculated on the total number of quoted securities.
it’s possible to highlight
- When the indicator rises above 80-85, the market has entered an overbought area and may have reached a short-term high.
- When the indicator falls below 20-15, the market has entered an oversold area and may have reached a short term minimum.
Some analysts also use the intermediate zone (50-45 points) to confirm the presence of an upward (when the indicator rises above 50 points) or downward (when the indicator falls below 45 points) trend.
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