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Moving average: using them to trade

The moving average is one of the most commonly used indicators and they are generally used for two things: determining the market conditions, and entering and exiting a trade.

What is a moving average indicator?

A moving average is a display of the average price of an instrument over a specific period of time. It is displayed as a line on the chart. The moving average line is constructed by taking the average price over a specific number of periods. Each average price is then plotted on the chart; usually it is the closing price of each candle that is used.

A moving average is an indicator that displays the average price of an instrument over a specific period of time.

 

Let's consider a 20 period moving average on a five minute chart. Each point of the moving average is calculated from the average closing price of the last 20 five minute candles. As each five minute candle forms, the moving average will continue to plot the average closing price of the most recent 20 periods.

  1. Simple moving average over 20 periods

A moving average is not always 20 periods, it is customisable, and so you can choose whichever period you would like.

  1. Simple moving average over 200 periods

The moving average is used to smooth the price action by producing a single line that makes it easier for traders to interpret market information, such as current trend direction.

  1. Steep angle to the upside denoting a strong bullish trend
  2. Flat angle in a range denoting a weak bullish trend
  3. Steep angle to the upside denoting a strong bullish trend

A trader can also use a moving average to make decisions as to which way to trade by observing whether the price is above or below a moving average.

If the price is above a moving average, it is higher than the recent price averages and thus it stands to reason that the price is moving up. Similarly, if the price is trading below a moving average it can be interpreted as the price moving down.

Typically, if price is above the moving average, it stands to reason that price is moving up. If price is below the moving average, it stands to reason that the price is moving down.

 

Take note that this is subjective, because any moving average is relative to the period for which you are observing the trend, and further moving averages on the chart must also be taken into consideration.

If the price is trading above a 20 period moving average, you might determine that the price is currently trending to the upside. However, the price could also be trading below the 200 period moving average, meaning the price is in an overall long term downtrend.

  1. 20 period moving average denotes short term uptrend
  2. 200 period moving average denotes that we are still in a long term downtrend

A trader can use these moving averages to not only determine what trend the price is currently in for the shorter term, but to also determine the overall longer term trend.

Using multiple moving averages to define a clear trend

By using multiple moving averages, a trader can determine a clear downtrend or uptrend. This is because when the market is clearly trending, the moving averages will move into the order of the periods away from the price.

Using multiple moving averages means that you can determine clear uptrends and downtrends.

  1. 200 period moving average
  2. 50 period moving average
  3. 20 period moving average
  4. 10 period moving average

Choosing the period

There are no specific rules when choosing the number of periods a trader should apply when using a moving average indicator, the choice is purely down to the individual.

The shorter the period of the moving average, the more quickly it will change with price, but will provide less reliable signals than a longer period moving average. Similarly, a longer period moving average will provide more reliable signals, but will react to price changes much more slowly.

The shorter the period of a moving average, the more quickly it will change, but it will provide less reliable signals. The longer the period, the more reliable the signal, but prices changes much more slowly.

 

For example, the 10 period moving average takes into account the last 10 periods and will therefore react to the change in price direction very quickly. The downside to this is that the trader may often receive false signals in the change of the trend because short term spikes in price can occur.

On the other end, the 200 period moving average takes longer to react and produces fewer false signals. The downside is that because the reaction is slower, the signals that are produced are much less frequent.

In the chart below we can see how the 10 period moving average (purple) changes direction in line much more quickly with the change in price, while the 200 period moving average (red) does not.

  1. 200 period moving average has not yet registered the new move
  2. 10 period moving average is in a downtrend

Different moving average types

You do not need to be concerned with the actual calculation of the different types of moving averages; almost every charting package will calculate this automatically and you only use the visual lines on the charts.

 

There are four types of moving averages:

  • Simple
  • Exponential
  • Linear weighted
  • Smooth weighted

The fundamental difference between these types of moving averages is how they are calculated. Due to this, they appear differently on the price chart.

The simple moving average uses each period with equal weighting in its calculations. The exponential, linear and smooth weighted averages emphasise the most recent periods in the calculations.
The simple moving average uses each period with equal weighting in its calculations. The exponential, linear and smooth weighted averages emphasise the most recent periods in the calculations. Consider the 50 period moving average on the following chart in conjunction with the different moving average types, you can see the difference in appearance.

  1. Linear weighted moving average
  2. Exponential moving average
  3. Simple moving average
  4. Smoothed moving average

Using moving averages as support and resistance

Moving average indicators can also be used as support or resistance for possible entry or exit points in the markets. What this actually means is that when the price comes into contact with the moving average on the price chart, traders watching the charts will then enter orders to either buy or sell. This essentially works in the same way as a horizontal support or resistance line.

When price comes into contact with the moving average on the price chart, if it is below, the moving average can act as resistance; if it is above, it can act as support.

If the price is below the moving average, then the moving average will act as resistance; if the price is above the moving average, it will act as support.
Moving averages are dynamic support and resistance because they change as the price moves.

  1. Simple moving average
  2. Price action uses moving average as resistance

 Moving average crossovers

Moving average crossovers can be used to determine when a trend has changed direction. The concept uses two moving averages of different periods to show the short term and the longer term trend in the price.

When the shorter term moving average and the longer term moving average cross each other, this can show that the trend has started to change direction. When observed, traders can use this to appropriately time entries and exits from the market.

When a short term moving average crosses below to above a long term moving average, this can signal that the trend is changing direction to the upside. Likewise, if a short term moving average crosses above to below a long term moving average, this can signal a change to the downside.

 

  1. Slow moving average
  2. Fast moving average
  3. Fast moving average crosses over the slow moving average

Summary

So far, you have learned that ...

  • ... a moving average is the average price of a currency pair calculated from the closing price of a specific amount of periods.
  • ... a moving average indicator can be used to determine the trend.
  • ... there are four main types of moving averages: simple, exponential, linear weighted and smoothed.
  • ... there is a trade-off between the reliability of a moving average and how quickly it will react to the change in trend.
  • ... moving average indicators can be used as support and resistance levels.
  • ... moving average crossovers can be used to determine a change in the trend.