By Michael Tibbits, YouCanTrade
What is a moving average?
A moving average is probably the most basic and widely used technical indicator. A moving average is generally used for trend identification – to see which way price is moving. Attention is given to the direction in which the average is moving and to the relative position of prices and the moving average. Rising moving average values and share prices above the moving average would indicate an uptrend.
How is a moving average calculated?
A moving average is an asset’s average calculated over a specified period of time, looking backwards. For example, a 10-bar moving average includes the last 10 bars (the 10 previous closing prices) of an asset’s value in its calculation. Each price point on the chart will show the average from earlier periods. The next day, the moving average replaces the earliest bar (which would then be the eleventh bar) with the most recent bar to calculate the current bar’s moving average. Moving averages are often used to obtain a smoothed value of an asset. An average over any number of bars can be applied to a chart. The less bars you include in the moving average, the more sensitive it will be to price changes. By default, moving averages use an asset’s closing price for the calculation. However, you can take a moving average using the opening price, high or low prices of each candle as well.
What do moving averages tell us?
Moving averages can be helpful in identifying trends. Moving averages can also help determine if an asset’s current price is relatively expensive or inexpensive. For example, if the asset price is trading above the moving average, the asset is relatively expensive compared to its moving average. If the asset is trading below the moving average, the asset is relatively inexpensive compared to its moving average.
Single moving average example
Let’s assume you’re looking at a stock chart of company XYZ and you want to know if the stock is currently trading higher or lower than average over the last 10 days. One way to do this is to plot a 10-bar moving average and set your bar to a daily interval. Each bar represents one day and a 10-bar moving average will be a 10-day moving average. If you plot the moving average and see the moving average is heading higher as you read the chart from left to right, it means the stock price has been steadily increasing in value, which may indicate an uptrend. On the other hand, if you plot the moving average, and see, from left to right, the moving average is moving lower, that may indicate the asset is in a downward trend.
Plotting multiple moving averages
Why plot one average when you can plot many? Many traders use a combination of moving averages to help determine trend changes in an asset’s price. Some popular combinations include plotting a 20-day moving average with a 50-day moving average. Since the 20-day moving average is a shorter length than the 50-day moving average, the 20-day would be considered the “fast” average and the 50-day moving average would be the “slow” average.
Just like the single moving average, attention is given to the direction in which the averages are moving relative to the asset prices and the values of the averages. An indication of an uptrend might be determined if the asset prices are trading above the “fast” average and the “fast” average would have values above the “slow” average. To determine a downtrend, simply reverse the logic. If asset prices are trading below the moving average values, and the “fast” average is below the “slow” average, that would indicate a downtrend.
Moving average crossovers
Moving averages are commonly used to anticipate changes in an asset’s direction. Traders using moving averages attempt to predict changes in a trend when the “fast” average crosses below or above the “slow” average.
For example, the “Death Cross” is a popular moving average crossover where the “fast” moving average crosses below the “slow” moving average. Typically, the most common moving averages used in this pattern are the 50-day and 200-day moving averages. This pattern is typically used to identify the beginning of a bearish trend.
Combining moving averages with volume
Moving averages are often accompanied by other indicators. The most popular indicator used to confirm the strength of a crossover is volume. Volume is the total number of shares traded in any given bar interval. Moving average crossovers accompanied by high trade volume are often considered to be more significant than crossovers accompanied by low trade volume. Therefore, moving average crossovers accompanied by high trade volume would be more significant in indicating a change in an asset’s price trend.
Looking for more? Stock traders who are looking to trade options want to know the most efficient way to learn about trading options. It starts by knowing anyone can learn to trade options if they are willing to put in the time and effort required. “Start Trading Options” is an in-depth beginner course that cuts through the confusing pricing concepts and jargon to explain what you need to know to place your first options trade with confidence. Learn more.