Moving Average

What is a Moving Average?

A Moving Average (MA) is a technical analysis indicator introduced by the renowned American investment expert Joseph E. Granville. It is used to smooth out price or other indicator fluctuations to better identify trends by calculating the average value of prices (or indicators) over a certain period and plotting it as a curve.

The calculation of the Moving Average is quite simple; it is obtained by averaging prices over a period to get the moving average value at each point in time. Moving Averages are commonly used to smooth price fluctuations, making long-term trends clearer. They help identify support and resistance levels of prices and trend change points. By observing the relationship between the Moving Average and prices, traders can attempt to determine the market's trend direction and strength and make corresponding trading decisions.

Types of Moving Averages

Based on calculation methods and application scenarios, Moving Averages can be classified into the following common types:

1. Simple Moving Average (SMA): The Simple Moving Average is the most basic type. It smooths price fluctuations by calculating the average price over a period.
2. Weighted Moving Average (WMA): Similar to the Simple Moving Average, but it assigns higher weight to the more recent prices, meaning recent prices have a greater impact on the Moving Average computation.
3. Exponential Moving Average (EMA): This is a widely used type of Moving Average. Unlike the Simple Moving Average, the EMA gives more importance to recent price data and is more sensitive to market changes.
4. Variable Moving Average (VMA): This type adjusts weights based on price volatility. It assigns smaller weights during periods of high volatility and larger weights during periods of low volatility.

Eight Rules of Moving Averages

There are some commonly used rules for Moving Averages that can help traders analyze market trends and make trading decisions. Here are the eight commonly used rules (as shown in the image below).

Buying Rules

1. When the Moving Average flattens out from a decline and starts to rise slightly, and the price breaks through from below the Moving Average.
2. When the price runs above the Moving Average, and during a pullback, it does not fall below the Moving Average and then rises again.
3. When the price runs above the Moving Average, falls below it during a pullback, but the short-term Moving Average continues to rise.
4. When the price is running below the Moving Average and suddenly plummets far from it, it is likely to approach the Moving Average.

Selling Rules

1. When the price runs above the Moving Average and continuously rockets for several days, moving further and further away from it.
2. When the Moving Average flattens out from a rise, and the price falls below the Moving Average.
3. When the price is below the Moving Average and does not break through it during a rebound.
4. When the price hovers above the Moving Average after a rebound, but the Moving Average continues to decline.

Advantages and Disadvantages of Moving Averages

As a technical analysis tool, Moving Averages have some advantages and disadvantages. Here are some key aspects:

Advantages

1. Smooths Price Fluctuations: Moving Averages can smooth price fluctuations, reducing noise and the impact of short-term volatility, making trends more visible.
2. Trend Identification: Moving Averages help identify long-term market trends. By observing the Moving Average's trend, traders can determine whether the market is in an uptrend, downtrend, or consolidation phase.
3. Support and Resistance: Moving Averages can act as support and resistance levels. When prices approach the Moving Average, it may provide support or resistance, helping to predict price rebounds or pullbacks.
4. Cross Signals: The crossing of Moving Averages can provide buy and sell signals. For example, the Golden Cross and Death Cross are common cross signals used to ascertain market trend changes and trade timing.

Disadvantages

Lag: Moving Averages are based on historical data, which introduces a certain lag. They cannot provide real-time market information and may miss rapid market changes.

Ineffectiveness in Choppy Markets: In choppy or sideways markets, Moving Averages may generate false signals. They might give cross signals, but the market may not have a discernible trend.

Not Suitable for All Markets: The effectiveness of Moving Averages varies by market. Some markets may be more sensitive to Moving Averages, while others may produce more noise, diminishing their effectiveness.

Single Indicator: Moving Averages are just one of many technical indicators and should not be used alone for trading decisions. Combining them with other technical indicators and analysis tools can provide a more comprehensive market evaluation.

Uses of Moving Averages

As a commonly used technical analysis tool, Moving Averages have several applications, including:

1. Trend Confirmation: Moving Averages can confirm market trends. When the price is above the Moving Average, and the Moving Average is trending upwards, it indicates a possible uptrend. Conversely, when the price is below the Moving Average, and the Moving Average is trending downwards, it indicates a possible downtrend. Traders can use the Moving Average direction to determine market trends and adjust their trading strategies accordingly.
2. Support and Resistance: Moving Averages can act as support and resistance levels. When prices approach the Moving Average, it may provide support or resistance. Traders can observe whether the price rebounds or breaks through the Moving Average to assess market rebound or breakout capability.
3. Cross Signals: The crossing of Moving Averages can provide trading signals. For example, when a short-term Moving Average crosses above a long-term Moving Average (Golden Cross), it is considered a buy signal. Conversely, when a short-term Moving Average crosses below a long-term Moving Average (Death Cross), it is considered a sell signal. Cross signals help traders identify market turning points and trading opportunities.
4. Trailing Stops: Moving Averages can be used as references for trailing stops. Traders can set stop-loss levels below the Moving Average to protect profits. If the price falls below the Moving Average, it could be a stop-loss signal, and traders might consider exiting the trade.
5. Multiple Moving Average Combinations: Traders can use multiple periods of Moving Averages for more confirmation signals. By observing the trends, crosses, and alignments of short-term, medium-term, and long-term Moving Averages, stronger trend confirmation and trading signals can be obtained.