Price action happens fast in financial markets. One minute a stock price may move up, then the next minute it’s heading down. However, most investors pay little mind to the short-term fluctuations in prices.
But how do investors weed out the noise of short-term volatility in market prices? Many use measurements called moving averages to spot longer-term trends.
Read on to find out what a moving average is and how you can use this technical analysis tool to improve your investment returns.
What Is a Moving Average (MA)?
A moving average is a statistical calculation for measuring long-term trends in the stock market. Moving averages smooth the choppy up and down movement the market is known for, making it easier for you to visualize trend direction and strength on a financial asset’s chart.
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In financial markets, moving averages are used to create a constantly updated average price with closing prices as the central data points. The moving average is a lagging indicator because it uses past prices to determine a trend, rather than trying to predict the future as a forward-looking indicator would.
How Does a Moving Average Work?
Moving averages work by plotting average prices over a period of time on a chart. Although most interactive charts can do the calculations and plot the moving average for you, it’s important that you understand how these calculations work.
The moving average starts with the first set of closing prices over the period’s time frame. With each day that passes, the oldest closing price in the average is dropped off and the newest price is added in.
For example, a 30-day moving average plots the average price over the past 30 days on the chart. This is calculated by adding the closing prices for the past 30 days together and dividing the total by 30. Then, at the close of each trading session, the closing price from the first day of the average is removed and the new closing price is added in. A line plotting these data points represents the moving average.
Check out Apple’s three-month stock chart below, complete with its 30-day moving average drawn in purple:
(Chart courtesy of Yahoo! Finance)
The blue line that tracks the stock’s day-to-day price movements fluctuates rapidly, making it difficult to determine a trend. However, the purple line, the 30-day moving average, smooths out these price movements. This shows that Apple’s stock has been moving downward gradually for the past three months. The stock’s recent upward movement has started to pull the 30-day moving average higher again, however, which suggests a reversal of this downtrend may be on the horizon.
Types of Moving Averages
There are two different ways to calculate moving averages. Moreover, the time frames used in the calculations make a difference in the data the moving average yields.
Simple Moving Average (SMA)
The simple moving average (SMA) is the easiest average to calculate. The SMA is made up of the raw price movement data, giving each day in the average an equal weight. The simple moving average plots the mean of price data over a predetermined number of days, with each closing price having an equal importance to the calculation.
Exponential Moving Average (EMA)
The exponential moving average (EMA) uses the same information but gives more importance to the most recent price data. The calculation for the EMA is a weighted average calculation because of the emphasis it puts on the most recent data.
This weight is created using a multiplier on the most recent price in the dataset. Multipliers in EMAs are determined using the following formula:
(2 ÷ (Time Frame +1) = Multiplier
So, for a 30-day EMA multiplier:
(2 ÷ (30 +1) = 0.0645
Multiplying the most recent price by the multiplier puts more emphasis on the most recent data. This results in an EMA that’s higher than the SMA when the most recent stock prices are up and lower when prices are down.
Take a look at the Apple chart below. The blue line is Apple’s stock price, the 30-day EMA is drawn in red, and the SMA appears in purple.
Notice how the red line (the EMA) reacts to movements in the stock price faster than the purple line (the SMA) does. This sensitivity makes it easier to catch recent price trend reversals by looking at EMA.
Short-Term vs. Longer-Term Moving Average
The time period covered by the moving average makes a difference as well. Short-term moving averages show short-term trends, while long-term averages signal long-term trends. Oftentimes, investors and traders alike use a mix of short- and long-term averages as indicators that let them know when to jump into or out of an investment.
Why Use Moving Averages?
There are two reasons investors and traders alike use moving averages:
To Define Trends
Most financial markets are volatile in nature. That’s because these markets depend on supply and demand for price movement. When there are more buyers than sellers, the prices of assets rise, and when there are more sellers than buyers, the prices of assets fall.
With high levels of volatility in financial markets, it may be difficult to determine the direction of a trend and when that trend is making a reversal. Moving averages help investors weed out the noise of short-term price changes and focus on the overall trend at hand.
To Find Entrance and Exit Signals
Choosing the best time to enter or exit a financial position is one of the most challenging aspects of participating in financial markets. Moving averages help make decisions to enter or exit an investment more simple.
Professionals use moving average oscillators and crossovers (described below) as signals that determine when they should buy or sell an asset. For example, when a short-term moving average crosses over a long-term moving average, the action acts as a buy signal that suggests it’s time for investors and traders to dive in.
How to Use Moving Averages
Moving averages are an important part of technical analysis. They make up multiple key indicators that signal when to buy and sell assets. Here’s what you need to know when using these tools.
Using Simple Moving Averages vs. Exponential Moving Averages
The exponential moving average is far more responsive to price movements because of the heavy weighting placed on the last piece of data in each dataset. This comes with advantages and disadvantages.
Trends are easier to read when using a simple moving average because it’s less responsive to price movements. However, the EMA is more sensitive to price movements, making reversals easier to spot. EMA generally gives buy and sell signals faster than the SMA, making it a perfect tool for a short-term trader.
Choosing a Time Frame
The time frame you choose when setting up a moving average makes a big difference in the trend that emerges.
For example, take a look at the chart for Apple stock below. The purple line is a 30-day moving average while the green line is a 10-day average.
As you see, the 10-day average is more uneven than the 30-day average and the two lines cross several times over the course of three months. Here’s how to know when to use one, the other, or both:
- Short-Term. Short-term averages are best used when investors and traders are interested in making short-term moves in the market.
- Long-Term. Long-term averages are best for determining long-term trends. They’re best used by investors who are interested in buying and holding an asset for a while.
- Both. Using short- and long-term moving averages together can help to determine the best time to buy and sell assets. When the short-term average crosses over a long-term average, it’s time to buy, and when it crosses below the long-term average, it’s time to sell.
Advantages of a Weighted Moving Average
The primary advantage of a weighted moving average like the EMA is that it responds to price movement much more quickly than a simple moving average. This sensitivity helps spot reversals more quickly, giving traders an opportunity to act earlier. The ability to tap into trends early gives a trader a leg up in the market. After all, time is money!
Limitations of Using Moving Averages
Moving averages are an important tool for those accessing markets, but there are limitations to consider. The most notable limitations to moving averages include:
- Purely Technical. Moving averages are technical indicators that derive their data solely from price movement. Investors should also understand the fundamental factors that explain why the movement is taking place and whether it’s likely to continue.
- Lagging. Moving averages are lagging indicators. It’s important to keep in mind that past performance isn’t always indicative of future price movements.
- Conflicting Signals. Moving averages can point to different trends when they span different periods of time. For example, a 10-day moving average could signal a buying opportunity at the same time the 200-day moving average for the same stock suggests it’s a long-term loser.
- Useless In Erratic Markets. When prices jump up and down frequently, it can be hard to determine a trend using moving averages.
Trading Signals From Moving Averages
Moving averages are used to generate trading signals known as technical indicators. Some of the most common indicators that use moving averages include:
Crossover
Moving average crossovers happen when a short-term moving average crosses over a long-term moving average.
When the short-term moving average, called the signal line, crosses above the long-term moving average, it’s a signal to buy the stock. Conversely, when the signal line crosses below the long-term moving average, the crossover is a sell signal.
Take a look at the chart below — a three-month chart of Apple stock with a 30-day moving average (purple) and a 10-day moving average (orange):
The shorter, 10-day moving average line in orange is the signal line. When the orange line crosses below the purple line, it suggests it’s time to sell Apple stock. When the orange line crosses above the purple line, it’s time to buy.
In the chart above, there are two buy and two sell signals. Can you find them?
Moving Average Convergence Divergence (MACD)
The moving average convergence divergence (MACD) is a momentum indicator that’s designed to determine trends and their momentum. The indicator is an oscillator that shows the relationship between two moving averages and the price of an asset.
The indicator is an oscillator that can be found on most interactive charts. It is derived from the 26-day EMA and the12-day EMA, which creates the MACD line. A nine-day EMA of the MACD acts as the signal line.
Like with moving average crossovers, traders who use MACD look for crossovers of the signal line and MACD line. When the signal line crosses above the MACD line, it’s considered a buy signal, while a cross below the MACD line is considered a sell signal.
The MACD data is generally shown in a sub-chart below the main chart:
In the case above, the MACD line is purple and the signal line is orange. Any time the orange line crosses above the purple line, it’s a sign that it’s time to buy the stock. Conversely, when the orange line crosses below the purple line, it’s time to sell.
Bollinger Bands
Bollinger bands are another oscillator created by plotting lines two standard deviations above and below the SMA. When the price moves closer to the upper band, the asset is believed to be overbought, suggesting it’s time to sell. On the other hand, when the price moves close to the lower band, it suggests the asset is oversold and it’s time to buy.
See the chart below:
The orange line is a 20-day simple moving average. The space between the upper and lower Bollinger bands is shaded in. Notice that when the price nears the upper band, downtrends tend to follow. On the other hand, when prices near the lower band, Apple stock tends to make a recovery.
Moving Average FAQs
Naturally, you might have a question or two about moving averages. You’ll find answers to the most common questions below.
What Does a Moving Average Tell You?
Moving averages tell you a few things. First and foremost, they’re great at pointing to trend directions. You can tell an uptrend is taking place when the moving average slopes upward and a downtrend sets in when the average slopes downward.
Moving averages are also used as technical indicators that signal to investors and traders when to buy and sell financial assets.
What Is a Good Moving Average to Use?
Simple and exponential moving averages, both short-term and long-term, have their pros and cons. The best moving average to use depends on your needs.
For example, if you’re looking for a stock that has been trending upward for a long time and is likely to continue, a long-term SMA is the way to go.
On the other hand, if you’re looking for a short-term opportunity to cash in on a new trend, short-term EMAs are the best bet.
Which Moving Average Is Best for Swing Trading or Day Trading?
Short-term traders tend to use the EMA rather than SMA. This is because these traders make their money by taking advantage of short-term trends in the market, and the EMA is more responsive to these types of trends.
What Is EMA In Forex?
The EMA works the same way in forex trading as it does for any other financial asset. It’s a weighted average of prices over a predetermined period of time with extra emphasis given to the newest data in the set.
What Is a 50-Day Moving Average?
A 50-day moving average is the mean (average) of closing prices of a financial asset over the past 50 trading sessions. The 50-day moving average is one of the more common technical indicators used to spot technical trends in stocks. It is often used to identify key technical support and resistance levels.
What Is a 200-Day Moving Average?
A 200-day moving average is the mean (average) of closing prices of a financial asset over the past 200 trading sessions.The 200-day moving average is a long-term indicator commonly used to identify much longer-term trends.
Final Word
Moving averages are a great tool for investors and traders alike. However, they shouldn’t be the only tool in your toolbox.
Before acting on a moving average signal, investors should research fundamental data that explains why the trend is moving in the direction it is and whether it’s likely to continue. Technical traders should use a mix of different technical indicators for the best shot at success in the market.