zenduck.me: Moving Average Explained 2023 Complete Guide with Examples

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How do you deal with uncertainty? 💡

While CNBC’s Jim Cramer has called 2021’s mid-Autumn market confusing, it can be wild at any time of any year. This fact remains true even in times of calm or boom as we’ve witnessed some of the big crashes of the last 100 years—the roaring 20s preceded the Great Depression and it was widely believed that mortgages were safe right up to the crash of 2008.

We believe that uncertainty—seen or unseen—is best faced with courage, a clear head, and a well-stocked tool shed. Moving averages are rather basic, yet essential, tools in this arsenal as they help you make sense of the sometimes chaotic price movements, trigger trade signals, and make up parts of the more complex technical indicators.

In this guide, we’ll be looking deeper into the nature and inner workings of moving averages, as well as how you can best use them to make a winning strategy.

What is a Moving Average? 🤔

A moving average (MA) is a statistical tool that helps you make better sense of stock price charts. The MA represents the average price for a specific period of time and is usually represented itself as a line imposed on the price chart for the said period.

Used on its own, it tends to indicate support and resistance, depending on whether it is analyzing an uptrend or a downtrend. A moving average is represented as a line—which is most often rising or falling.

That is to say, in case of an uptrend, the moving average line tends to stay beneath the prices and acts as support—the point below which the prices are unlikely to fall under. In case of a downtrend, the moving average stays above the chart and indicates resistance—the value the prices are unlikely to reach or breach.

This makes moving average a useful tool in technical analysis as it can generate trading signals, along with various other indications as to what is happening to the prices—especially when the support and resistance levels are crossed.

Furthermore, the moving average is very flexible and customizable and can be applied to almost any amount of time—5-day, 20, 50, 200, pretty much anything you want. Additionally, you can apply results for different periods to gain better insight into the security you are looking to trade.

These traits make the moving average very popular and you’ll often see headlines like Facebook recovering above its 200-day simple moving average. But do you see the keyword here? Simple moving average. 

This indicator comes in two main flavors—simple and exponential—and they have their own quirks, uses, and formulas.

How to Calculate a Moving Average 💭

The first thing to note here is that all of the premium stock brokers and charting software can calculate moving averages—and other indicators—in your stead. Still, it is good to have some idea of how to get the figures yourself.

Simple moving averages (SMAs) are rather deserving of their name as they are very simple to calculate. You’d just add up the average price for every one of the periods you are analyzing and then divide by the number of periods.

Simple moving average=(Average for period 1+Average for 2+Average for 3+…)/number of periods
So if you are looking for the simple moving average for a 7-day period where the daily averages were $10, $11,$12,$11,$10,$9,$11 Monday to Sunday:

So the simple moving average is $10.57

The exponential moving average (EMA) attempts to be more responsive to price changes by weighing more heavily the most recent periods—making it a more complicated calculation.

This one is a trilogy—like Lord of the Rings or Star Wars—whereby you take the simple moving average as a baseline, calculate the modifier based on the period, and then finally bring these together for a final formula to get the current exponential moving average.

The caveat is that in the first element, the simple moving average is here treated as the EMA for the previous period. Building on our example, the previous exponential moving average would be 10.57.

The formula for calculating the modifier goes as follows:

Note the asterisk by the number 7. This is because that number is going to change based on the desired period and is 7 in this case as that is the period we are looking at in our example.

So, in this case, the modifier would be 0.25.

To bring it all together we would also need the latest closing price which we will, once again for our example, set at $11. So, the current exponential moving average would be $10.68 following the calculation:

The Types of Moving Averages 📊

Now that we know how to calculate them, let’s delve into what simple and exponential moving averages can tell you. The first thing to note—one that applies to SMA and EMA—is that they are lagging indicators.

This means that they look at historic data, and can plot out things like Tesla stock going up over a previous period of more than 6 months—but don’t give any predictions for the future. That is the job of the so-called leading indicators.

However, lagging indicators are still useful for planning your strategy as, unless the changes are completely sudden and instantaneous, the past often holds the key to the future. 

This key lies in the breakouts and crossovers that the moving averages can show you, and in how timely and accurately these indicators can reveal this information. This is where the SMA and the EMA diverge.

Since the exponential moving average gives more weight to the freshest changes it tends to be more reactive—its line follows the actual chart more attentively. This could lead you to believe that the EMA is the better choice, especially if you are very time-sensitive like when day trading—but this isn’t really the case.

As a rule, EMA’s reactiveness means it will detect short-term anomalies just as likely as actual price and trend changes making it somewhat more prone to false positives. This same logic can be applied to short-term moving averages as opposed to long-term ones.

The lesser the number of days you are looking at, the changes will be more starkly reflected. This will in turn also generate more timely signals as well as more false positives.

Generally speaking—just as is the rule with other technical indicators—a hybrid approach is highly advisable. For example, applying both the short and long-term averages to a chart can help confirm a trend, or generate a death cross or a golden cross.

Using Moving Averages for Trading 📈

A major effect you should be after when using moving averages—and any other technical indicator—is compounding. Each and every one of the technical indicators has shortcomings and can misread the market. However, the more of them you use, the better and more precise your results will be.

Moving averages are a bit of an oddball in this scenario. Since they are a very basic indicator they can be used in convergence with themselves. As we’ve mentioned before, a very common strategy is taking a MA for a longer and shorter period and superimposing both on a chart.

This strategy works pretty well no matter what trade you are plying—it works for stocks, options, futures, and moving averages form the basis for some of the key forex technical indicators. That being said, these indicators are used a bit differently depending on the form of trading you are into—options have differences to stocks and the same applies to futures and forex, as well as to day trading as opposed to long-term investing.

Towing the Line 📋

Though this should only serve as a jumping-off point, moving averages offer some useful data even if looked at on their own. As we’ve already discussed, the moving average simplifies the understanding of the price chart—a line pointing down shows a downtrend, and a line pointing up an uptrend.

Furthermore, once you identify the trend, you know if the moving average is showing support and resistance. In a downtrend, the prices going above the line represent a sell signal, and vice-versa.

This isn’t definitive as it can be a jolt, a last opportunity to buy at a good price, or sell before a crash, or a trend reversal—but no matter what it is it should put you on high alert. The next step would be confirming this signal by a more thorough analysis.

Crossovers 💸

Crossovers are the first, and simplest step of this more detailed look. Basically, you’d want to select two different moving averages—a 50-day and 200-day one for example—and seek a crossover.

Using this example, a situation in which the shorter, 50-day average, crossed above the longer, 200-day average, is called a golden cross. This is a buy signal as it indicates that the trend is going upward taking the prices with it.

A very notable 2021 example of the golden cross came in late summer when the prices of Bitcoin entered this state. 

A golden cross—or any cross for that matter—is no sure confirmation though as it became clear shortly after BTC entered this state. Its failure to reflect the favorable predictions was blamed by some on the FED, which just might have been correct as various external factors often affect the market either vicariously or directly.

That being said, Bitcoin did deliver shortly after this accusatory article was published—the prices went from $43,575.10  on the 22nd of September to $64,036.00 on October 20th.

As is often the case with great heroes, the golden cross has its notable nemesis—the death cross. The death cross represents the exact opposite situation. When the short MA, 50-days in our example, crosses below the long MA, 200-days, it creates a sell signal as it indicates that the trend is shifting downward.

Combining Moving Averages with Other Indicators 💰

The fact that you can combine moving averages with moving averages doesn’t mean you should limit yourself to only one tool. MAs tend to work best when used with other technical indicators, especially the ones showcasing completely different things like momentum or volume.

They can also be used with other support and resistance indicators in order to confirm a conclusion, or cast doubt upon it. These confirmations can be especially valuable when dabbling in riskier trading like binary options where you’d really want all the certainty you can get from all the important technical analysis tools at your disposal.

Furthermore, while moving averages are relatively simple, they can form complex and reliable systems. Moving average convergence/divergence (MACD) is a very popular technical indicator incorporating MAs in its very essence.

MACD uses the distance between the longer period average with the shorter average to showcase the momentum of the current trend—and can warn you of a reversal in case the lines cross, or the security being overbought or oversold if the price goes out of bounds.

Just as an example of a synergy between different indicators, MACD is often used in tandem with the relative strength index (RSI). Since the RSI looks at how overbought or oversold a security is, which is one of the things MACD can show as well, together they give fairly reliable trade signals and trend reversal warnings.

Limitations of Using Moving Averages 🚫

The most important thing to remember is that moving averages are social animals. The market can either oblige their conclusions or completely ignore them and the best way to be sure is to look at as many technical indicators as you can at least somewhat reliably understand.

This diversification of tools becomes especially crucial when there are a lot of price movements that can make moving averages hardly readable—which is especially the case for those looking at shorter periods.

Additionally, as moving averages are lagging indicators, they don’t really give insight into future prices. This makes any conclusions you reach prone to human error as well as to the ever-present potential for technical mistakes and false signals.

Conclusion 🏁

While far from perfect, moving averages give clarity to landscapes that are often lacking it. Furthermore, they don’t need to be flawless as trading stocks can’t be played using only big moves—a death (or victory) by a thousand cuts is what you should generally be aiming for.

Their simplicity is another great feature as tried and tested methods without too many moving parts tend to be most long-lasting. This trait might yet prove their greatest strength as both the proliferation of mass communication and the ambitions of certain companies to provide us with 24/7 trading might give rise to even more dynamic markets.

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