What are Moving Averages used for?
Moving Averages are indicators falling in the “trend-following” category. Its purpose is to help traders predict upcoming trends in a graph and has become a widely used tool amongst technical analysts as it is reasonably easy to understand and put to use.
Its basic mechanic lies within the calculation of an asset’s average value through a set period of time. However, a single averaged value is not applicable as it does not serve as a complete indicator, therefore MAs are composed of various other averaged values that connect within a graph.
Moving Average variations
There are two main types of Moving Average indicators.
SMA (Simple Moving Average)
Simple Moving Averages takes regard to generating an average price from a set of data. If an SMA of a span of 5 days is required, there would be 5 sets of data , including the closing price of the asset in each day. After a day has passed, the closing price of that day would replace the data from the first day as it has surpassed the age of 5 days.
EMA (Exponential Moving Average)
The Exponential Moving Average, much like the SMA, is also an indicator that employs the use of past price data, but rather focuses upon the more recent sets. This allows the acquired averaged value to be based upon more recent data, suiting the use for short-term market volatility projection.
1. Graph simplification (Smooth)
Market volatility does not affect MA-drawn graphs as the indicator allows investors to view market graphs accordingly to the calculated averaged asset value, therefore, short-term volatility or noise would be mitigated.
2. Market trend prediction
Moving averages are functional in the quest of prediction market trends. When an MA graph travels upwards, it could be a plausible indication that a market would travel uptrend. In contrast, if it travels downward, the asset’s price could also be heading in a downtrend.
As MAs take account of the past data found in graphs, its graph would travel behind the price graph in the same direction, but at a slower pace. Therefore, meaning that when entering a downtrend market, the MA would always travel lower.
Moreover, MA graphs using sets of data from shorter time periods would float higher than ones utilizing longer time periods, indicating that the market could be heading into an uptrend. However, if the two are moving in a contrasting direction from aforementioned, the market could plausibly be heading in a downtrend motion.
3. Used as resistance and support lines
Other than being an indicator that helps simplify graphs for traders and designate a market’s movement, MAs are also adept in being used as resistance and support lines. In exemplification, in uptrend markets, MAs can be used as support lines and as resistance lines in the contrasting situation. Additionally, the higher the amount of averaged sets data, the more strengthened these lines become.
To illustrate, if an asset’s price that once traveled in an uptrend motion, dipped to an SMA 200 days line (an SMA calculated with data from the past 200 days), the graph would most likely show reversal signs. However, if a graph falls to an SMA 5 days line, the price graph could potentially pause and hover in that area, before continuously dipping once again.
4. To show signals: purchase or sell
MAs are also capable of identifying signals for purchase or selling windows for a trader. A crossover of two MA lines indicates that there is fluctuation in the market, meaning that traders could possibly seek advantage from this situation.
The main factor traders look out for is when two MAs, either SMA or EMA, with varying sets of past data intersect. For example, if an EMA of 7 days crosses over another of 35 days to hover above the higher valued EMA, a “Golden Cross” is performed, indicating that an uptrend market. In contrast, if the EMA with lower valued sets of data, the EMA of 7 days crosses over and floats under the high valued EMA, a “Dead Cross” is displayed.
Duration and Time Frame
The matters of duration and specific timeframe is integral for the use of Moving Averages and different durations can produce varying MAs, which in return would result in varying outcomes.
Short-term traders have been found to use MAs for short-term investment, wherein the time frame used is encircled around only a few minutes or hours. By setting an MA of such manners, traders are able to predict and manage upcoming volatilities that may arise.
In opposition, long-term traders have been found to sustain their asset investments through using time frames in the manner of days or months, producing a longer MA. By doing so, the MA line would be accurate and sustain less fluctuation, proving more valid.
With Moving Averages calculating values through the use of past sets of data, any sudden movements on a graph would not immensely affect an MA, which could be damaging to traders that employ the use of this indicator as their MA might show signs far too slow.
Furthermore, another downside is that when a market is moving sideways or with unclear trends, crossovers can be inaccurate as they may occur often due to the sideways motion.
The Moving Average is a widely used indicator and plays an important role in many investors’ strategic planning as it can play many roles. However, it is integral that traders are aware that not every signal the MA displays will be as hoped. For maximum accuracy and risk management, traders are advised to be cautious of its usage, while also employing the use of other indicators as well.