What Are Moving Averages and How Do They Work?
Traders rely on technical analysis in order to predict the next market movement and as a result, maximize their profits. The technical analysis makes use of chart patterns and indicators so they can deduce trading opportunities. Among the most commonly used tools based on this principle are moving averages.
What are moving averages and how do they work?
Moving averages (MA) are the most frequently used and oldest technical indicators used in trading. This indicator has the role of analyzing past and recent data (usually that which is related to prices) by summing and calculating the average over a determined period.
The mean values resulted from these calculations are called “moving”, and these values are recalculated over and over again when new data is found. As it develops, the oldest value is removed from the average and the latest values are added in the equation.
This process goes under the term of “smoothing” and it has the role of lessening the impact of temporary data oscillations, making data linear, showing the trend in a more obvious manner and featuring the above and below values more clearly. The most common types of moving averages are: simple, exponential and linear.
Seeing as moving averages can only use events that have already taken place, they are categorized as trend following or lagging indicators. These are often used by other indicators such as Moving Average Convergence Divergence (MACD), Bollinger Bands, Percentage Price Oscillators in their own calculations.
Moving averages are used mainly to confirm a trend, determine which direction it will be taking, recognizing a flat market and if reversals are possible.
The main factor which is required in the calculation process of a moving average is a period or several periods, and most moving averages are based on the prices on which the market closes.
In order to fully understand moving averages and their use, one must also have a full grasp of how trends work. A trend represents the direction in which a price moves. There are three types of trends which cryptos can follow:
- An uptrend, or bullish trend, is when the markets are experiencing rising prices.
- A downtrend, or bearish trend, is when the markets are seeing drops in prices.
- A sideways trend is when market prices are moving sideways.
It should be noted that prices rarely go through a linear movement. This is why moving-average lines are used to determine the direction of the trend.
Types of Moving Averages
– Simple Moving Average
The most basic and most commonly used of Moving Averages is the Simple Moving Average. It involves calculating the unweighted mean (sum of values divided by their number) of data from an established number of time frames. After a new value is introduced in a new period, the oldest one is removed, which will result in a new calculation taking place.
– Exponential Moving Average
This type of indicator involves more complex calculations in comparison to the simple moving average as it weighs more of the recent data in the set of values. Then it computes the average of all the previously entered data without excluding any earlier entries when new ones are made available. Each value’s weight decreases exponentially.
– Weighted Moving Average
The last indicator is called the Weighted Moving Average, and it puts emphasis on the most recent price entries to guarantee they generate a more relevant impact on the result when compared to previous entries. The weighting of an entry decreases as the arithmetical progression is carried out, meaning that there is a fixed difference between data points, and 1 is the number most frequently used.
How to Interpret Moving Averages
- Take into account the length of the used periods. A certain number of closing prices are required in order to calculate a moving average. This might pose some problems when it comes to moving averages for assets that have just entered the market, as they have little historical data.
- Moving averages are indicators which depend on past instances, meaning that they are always behind the current trends. This implies that even the newest signals are delayed to some degree, which will lead to a larger lag that is directly proportionate with the length of the moving average.
- Moving averages can be determined by inputting closing prices, opening prices, monthly prices, weekly prices as well as the intraday prices of your asset.
- As the price fluctuations of an asset are higher, so are the chances of receiving false signals.
Moving averages are useful tools in a trader’s arsenal. The greatest advantage of this type of indicator is that it can help determine the current market trend or identify any possible reversals of the trend in question. Of course, as each trader has his or her own style, there are many ways in which one can employ moving averages, therefore, how you apply these indicators to your strategy is completely up to you.