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Moving Averages

Moving Averages

Most literature written on technical analysis, more specifically technical indicators, begins with Moving Averages. As its name would suggest a moving average calculates an average of price range over a specified period. For example, a 10 day moving average gathers the closing price (or the open, high or low) of each day within the 10 day period, adds the 10 prices together and then of course divides by 10. The term moving implies that as a new day's closing price is added to the equation, the day that is now 11 days back is dropped from the equation. Figure 1 shows an example of a simple moving average line placed on a candlestick chart.

The example in figure 1 outlines what would be considered a Simple Moving Average. There are at least 7 varieties of moving averages, we will focus on the following three:

Simple Moving Averages
Exponential Moving Averages
Weighted Moving Averages
What are moving averages trying to tell us?

It is essential that you understand what a moving average is trying to tell you. A moving average calculating the last 30 days of prices in the market essentially represents a consensus of price expectations over that 30 day period.

Understanding a moving average is at times as simple as comparing the market's current price expectations to that of the market's average price expectations over the time frame that you are viewing. The average gives us a range that traders are comfortable trading within.

When prices stray from this zone, or from the moving average line, a trader should begin to look for potential entry points into the market. For example, a price that has risen above the moving average line typically implies a market that is becoming more bullish. Just the opposite, when prices begin to fall below moving average lines the market is becoming visibly bearish.

Notice the angle of the moving average shown above at various points across the chart. Moving averages not only give traders a much smoother look at the true trend of the market, they also offer keen directional insight found in the angle of the moving average line. Erratic sideways markets tend to be represented by moving average lines that are flat or sideways, whereas markets that are beginning to trend strongly in one direction or another will begin that trend with a strongly angled moving average line.

Simple Moving Averages

Calculating simple moving averages is really quite simple (no pun intended). As was outlined in the beginning of this section the sum of all closing prices is divided by the number of days in the equation. With each new day the now oldest day that is no longer a part of the time frame is subsequently dropped from the equation. A simple moving average is considered a lagging indicator. In fact, the simple moving average perhaps epitomizes the meaning of lagging indicator in that its visual data often comes a bit after the fact. Nevertheless, simple moving averages are an indication of where the price range should be trading at. When prices begin to break away from the moving average line in conjunction with a sharply angled moving average line – basic mathematics is indicating a move up or down in the market. The down side when observing lagging indicators is that the prediction often comes too late; thus the reasons for other types of moving averages, averages that more heavily weigh recent data and can offer more rapid predictions.

Exponential Moving Averages

Exponential and weighted moving averages attempt to resolve the issue of lagging directional forecasts. This is done by placing greater emphasis on more recent price data. Instead of evenly distributing plotted points of a moving average across all candles in the period, a weighted or exponential moving average puts more emphasis on the most recent data; allowing the angle of the moving average to react more quickly.

Reading moving averages is about comparing an average view of the market's recent trends to an actual view of recent price data. Notice in figure 4 that the exponential average reacts more quickly to price chance than does this simple moving average.

The Moving Average Cross

The moving average cross is a tool that many traders use. As can be seen in figure 5 below there are two moving average lines plotted on this chart:

The idea is to combine a short term moving average with a long term moving average. For example, a 10 day moving average on top of a 20 day moving average. Of course the shorter moving average period will react more quickly to price direction, whereas the longer moving average period will be represented by a smoother less volatile line. When the two lines cross this is considered an indication of a quickly approaching trend reversal or change in price direction. As always, watch for the angle of the moving average line, particularly the shorter time frame (in this case the 10 day moving average). When lines cross with a sharp angle and an obvious separation from one another this may be an indication of a change in price direction. See figure 6 below.