Major Uses of Moving Averages

Moving averages are the basis of chart and time series analysis. Simple moving averages and the more complex exponential moving averages help visualize the trend by smoothing out price movements. Charting analysis can be traced back to 18th Century Japan, yet how and when moving averages were first applied to market prices remains a mystery. It is generally understood that simple moving averages (SMA) were used long before exponential moving averages(EMA), because EMAs are built on SMA framework and the SMA continuum was more easily understood for plotting and tracking purposes.

Some of the primary functions of moving averages are to identify current trends and trend reversals, measure the strength of an asset's momentum and determine potential areas where an asset will find support or resistance.

Trend Identification

Identifying trends is one of the key functions of moving averages, which are used by most traders who seek to "make the trend their friend". Moving averages are lagging indicators, which means that they do not immediately predict new trends, but confirm trends once they have been established. A stock is deemed to be in an uptrend when the price is above a moving average and the average is sloping upward. Many traders will only consider holding a long position in an asset when the price is trading above a moving average whereas he will use a price below a downward sloping average to confirm a downtrend. This simple rule can help ensure that the trend works in the traders' favor. As you can see in the Figure given below, when a moving average is heading upward and the price is above it, the security is in an uptrend. Conversely, a downward sloping moving average with the price below signals a downtrend.

Another method of determining trend is to look at the order of a pair of moving averages. When a short-term average is above a longer-term average, the trend is up. On the other hand, a long-term average above a shorter-term average signals a downward movement in the trend.

Trend Reversal

Moving average trend reversals are formed in two main ways: when the price moves through a moving average and when it moves through moving average crossovers. The first common signal is when the price moves through an important moving average. For example, when the price of a security that was in an uptrend falls below a 50-period moving average, like in the Figure given below, it is a sign that the uptrend may be reversing.

The other signal of a trend reversal is when one moving average crosses through another. For example, as you can see in the Figure given below, if the 15-day moving average crosses above the 50-day moving average, it is a positive sign that the price will start to increase.

If the periods used in the calculation are relatively short, for example 15 and 35, this could signal a short-term trend reversal. On the other hand, when two averages with relatively long time frames cross over (50 and 200, for example), this is used to suggest a long-term shift in trend.

Momentum

Many beginner traders ask how it is possible to measure momentum and how moving averages can be used to tackle such a feat. The simple answer is to pay close attention to the time periods used in creating the average, as each time period can provide valuable insight into different types of momentum. In general, short-term momentum can be gauged by looking at moving averages that focus on time periods of 20 days or less. Looking at moving averages that are created with a period of 20 to 100 days is generally regarded as a good measure of medium-term momentum. Finally, any moving average that uses 100 days or more in the calculation can be used as a measure of long-term momentum. Common sense should tell you that a 15-day moving average is a more appropriate measure of short-term momentum than a 200-day moving average.

One of the best methods to determine the strength and direction of an asset's momentum is to place three moving averages onto a chart and then pay close attention to how they stack up in relation to one another. The three moving averages that are generally used have varying time frames in an attempt to represent short-term, medium-term and long-term price movements. In the Figure given below, strong upward momentum is seen when shorter-term averages are located above longer-term averages and the two averages are diverging. Conversely, when the shorter-term averages are located below the longer-term averages, the momentum is in the downward direction.

Support and Resistance

Another major way in which moving averages are used is to identify support and resistance levels. Moving averages act as a support in an uptrend and resistance in a downtrend. It is not uncommon to see a stock that has been falling stop its decline and reverse direction once it hits the support of a major moving average. Many traders anticipate a "bounce off" of major moving averages and use other technical indicators as confirmation of the expected move.

A short-term uptrend might find support near the 20-day simple moving average, which is also used in Bollinger Bands. A long-term uptrend might find support near the 200-day simple moving average, which is the most popular long-term moving average. If fact, the 200-day moving average may offer support or resistance simply because it is so widely used. It is almost like a self-fulfilling prophecy.

However a move through a major moving average is often used as a signal by technical traders that the trend is reversing and once the price of an asset falls below an influential level of support, such as the 200-day moving average, it is not uncommon to see the average act as a strong barrier that prevents investors from pushing the price back above that average. Hence, what was acting as a major support in an uptrend is now a major resistance. This resistance is often used by traders as a sign to take profits or to close out any existing long positions. Many short sellers will also use these averages as entry points because the price often bounces off the resistance and continues its move lower.

Below chart shows the NY Composite with the 200-day simple moving average from mid 2004 until the end of 2008. The 200-day provided support numerous times during the advance. Once the trend reversed with a double top support break, the 200-day moving average acted as resistance around 9500.

The support and resistance characteristics of moving averages make them a great tool for managing risk. The ability of moving averages to identify strategic places to set stop-loss orders allows traders to cut off losing positions before they can grow any larger. As you can see in the below Figure, traders who hold a long position in a stock and set their stop-loss orders below influential averages can save themselves a lot of money. Using moving averages to set stop-loss orders is key to any successful trading strategy.

Limitations of Using Moving Averages

The advantages of using moving averages need to be weighed against the disadvantages. Moving averages are trend following, or lagging, indicators that will always be a step behind. This is not necessarily a bad thing though. After all, the trend is your friend and it is best to trade in the direction of the trend. Moving averages insure that a trader is in line with the current trend. Even though the trend is your friend, securities spend a great deal of time in trading ranges, which render moving averages ineffective. Once in a trend, moving averages will keep you in, but also give late signals. Don't expect to sell at the top and buy at the bottom using moving averages. As with most technical analysis tools, moving averages should not be used on their own, but in conjunction with other complementary tools. Chartists can use moving averages to define the overall trend and then use RSI to define overbought or oversold levels.