Contents of this article
The moving average (MA) comes in two most popular forms: the simple moving average (SMA) and the exponential moving average (EMA – Exponential Moving Average). Its main advantage is that it smooths out the price chart and, used correctly, can lead to good trading results. It is the first technical indicator you need to know when studying technical analysis.
The two most common types of moving average
The most common type is the simple moving average (SMA), calculated as the arithmetic mean of a stock’s closing prices over X sessions. For example, to calculate the 50-day SMA, you add up the closing prices of the last 50 trading sessions and divide the result by 50.
There are many types of moving average, designed around different ways of weighting the sessions, but traders mainly use the simple moving average (SMA) and the exponential moving average (EMA – Exponential Moving Average).
The difference between these two moving averages is that the SMA gives equal weight to the prices of all the sessions in the period, while the EMA gives more weight to the most recent sessions, although this difference does not affect the analysis very much. The SMA is smoother and reacts more slowly to the latest price action, which helps when there is a false price spike and stops traders from rushing into a losing trade. The EMA, by contrast, reacts faster to the latest price action and lets traders get into a new trend sooner – with more noise, of course.
We can see that the EMA30 (yellow) reacts faster to price than the SMA30 (red) at important turning points.
Now that we have explained the difference between the two most widely used moving averages, let’s look at how to use them.
Using moving averages to gauge the trend
The first and most obvious use of a moving average is to smooth out the price trend. You can tell whether price is rising or falling by looking at the current direction of the MA, which is visually easier than looking directly at the price chart.
In my experience, we can use MAs with periods of 10–30 to gauge the short-term trend, 50–100 for the intermediate trend, and the MA200 for the long-term trend.
A simpler way to identify the trend is to look at the relative position of the MAs: when the short MA is above the long MA, that signals an uptrend; conversely, when the short MA is below the long MA, we may be in a downtrend.
Once again, remember our key rule: do not trade against the trend.
Using moving averages to identify buy and sell signals
Traders can use moving averages to spot the trend of a stock or of market indices such as the VN-Index. The simplest way is to plot a moving average of a specific period on the chart and trade the crossovers between price and the average. In other words, if price crosses above the moving average, we can open a long position, and if price moves below the moving average, we can open a short position.
You can also use two moving averages: one with a short period (the fast MA) and one with a long period (the slow MA). The fast MA takes the place of price: when the fast MA is above the slow MA, the trader can open a long position, and when the fast MA is below the slow MA, the trader can choose a short position.
Using moving averages to gauge trend momentum
As traders, we always want to find buying opportunities in the stocks with the strongest upward momentum, and this can be measured with moving averages.
I usually call the gap between the short and long MAs the “value zone”, and the widening or narrowing of this zone gives us an important signal about the momentum of the current trend. When the value zone widens, the current trend’s momentum is strong; when it narrows, that warns that momentum is weakening and the current trend may be about to reverse.
Which moving average is best for trading?
A question most traders probably ask is which MA is best – or which MA period should I trade with?
In my research on the market and backtesting over the past 15 years, I have found that the crossover of the 10-day EMA and the 50-day EMA is the strongest mechanical signal for entries and exits. It is a great signal for starting to check whether a chart has trended historically. In another study, buy and sell signals from the crossover of the 13-day EMA and the 48.5-day EMA produced the highest average return (16.88%).
When assessing the long-term trend, a strategy based on the 200-day moving average is the most important mechanical signal for filtering long-term trends, based on my experience studying hundreds of charts. The simple trading rule is: buy when price crosses above the 200-day SMA and exit when price crosses below the 200-day SMA.
Choose one or two moving averages that suit you and learn to use them well. You will be surprised by how useful this simple yet highly effective indicator can be.
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Happy trading !
