If you are wondering whether a prospective asset (stock, currency, etc.) is currently overvalued or undervalued, one of the first things you will want to do is compare the current price to the average price. However, while this may be obvious to most traders, it immediately raises several questions. How do you determine the average price of a stock? Are prices from 10 years ago as relevant as prices today?
As you would probably expect, the term “average” can actually have several different interpretations. Depending on your preferred trading timeline (day trading versus position trading), availability of price data, and various other factors, certain averages will likely be much more useful than others.
A moving average, as the name might suggest, is an average that moves in real time. If you are looking at a daily moving average, for example, the total data set will move with each passing day. In other words, after one trading period (which can be defined as you like) passes, the beginning of the data set will move one period forward. A 26 bar moving average will always contain the most recent 26 trading periods.
Moving averages are useful because they allow you to detect price movements that may have otherwise gone unnoticed. Many active traders will look at multiple different moving averages—such as a 9 day moving average and a 26 day moving average—simultaneously, in order to get a more complete picture of the market.
There are a few different types of moving averages, including simple moving averages, exponential moving averages, smoothed moving averages, and weighted liner averages. In this article, we will briefly define each type of moving average. We will then go on to describe how to effectively trade using moving averages.
Simple Moving Averages
The Simple Moving Average (SMA) is also frequently referred to as the arithmetic moving average. This particular moving average is both the easiest to calculate (when done by hand) and the easiest to understand. The average itself is simply the mean value of all prices occurring during the trading period. So if closing prices were $5, $9, and $10—for example—the 3 period Simple Moving Average would be $8. This is the only moving average that treats all trading periods (within the data set) equally.
Exponential Moving Averages
The theory behind Exponential Moving Averages (EMA) is that, while all recent prices have some sort of analytic value, the most recent closing prices ought to be considered the most important. Exponential Moving Averages are calculated by taking the simple moving average (mentioned above) and making a compounding adjustment that values yesterday’s closing price the most. The further back in time a closing price might be, the less influence on the Exponential Moving Average that particular price will have.
Smoothed Moving Averages
Smoothed Moving Averages are likely used the least of all moving averages mentioned in this article, however, they are still important to understand. These averages are also sometimes referred to as a Modified Moving Average (MMA) or the Running Moving Average (RMA). While other moving averages have an implied “smoothing factor”, the smoothed moving average will have a smoothing factor that directly changes with the number of periods (N). Some traders believe this average corrects for some of the problems that come with the Simple Moving Average.
Weighted Moving Averages
The weighted moving average is often compared to the exponential moving average, due to the fact that it places an extra emphasis on closing prices that have occurred more recently. However, instead of using an exponential formula to make this adjustment, the Linear Weighted Moving Average (LWMA) uses a linear formula. This can help offer a “happy medium” where the significance of time-sensitive events has been clearly adjusted for, without the more extreme method of weighting that the EMA creates.
Which Moving Average is best for my trading strategy?
Depending on how volatile a price has been, it is very possible that an increase in prices can coincide with a decrease in any moving average metric (and vice versa). This is due to the fact that once a new price has been added to the data set, the oldest existing data point is bumped into the historical record. With each new data point replacing an old one, the most important thing for you to ask yourself is “what does this new information mean?”
Generally speaking, more volatile markets will require you to consider more recent information to be the most important. If you are a long-term trader who trades forex, bonds, or index-supported stocks, then a Simple Moving Average will likely be sufficient. However, if you are trading risky assets on a frequent basis, then you can expect recent data to have an exceptionally large impact on future prices.
Using LWMA or even Exponential Moving Averages will amplify current price trends and make it easier for you to correctly identify positions that will actually be profitable. There is a risk, however, that EMAs will overemphasize market anomalies—sometimes called “hiccups”—meaning that it will still be important to be cautious.
How can I use Moving Averages to enhance my trading strategy?
Moving averages, of all varieties, are among the most common technical indicators for traders. Technical indicators make it possible for traders to find additional price trends, trading opportunities, and historic patterns that could not be deduced by simply looking at a price chart. There are quite a few ways that moving averages can be leveraged to increase your performance as a trader.
- Experiment with Different Averages: both simple and adjusted (linear, exponential, smoothed) averages have their share of pros and cons. By experimenting with multiple different averages, you can find the one that’s right for you.
- Use other technical indicators to test the strength of anomalies: if an EMA is producing a strong “buy” signal while the Simple Moving Average is telling you to hold, consider using other technical indicators—volume, relative strength, and many others—to help determine the ideal position.
- Know your preferences (and limitations): the strategy that is right for you will depend on the level of risk you are willing to take and the amount of trades you can make each period. These variables will have a direct impact on whether you should open or close in response to each moving average signal.
- Use retroactive data: in order to determine whether moving average signals have significantly correlated with profitable outcomes in the past, take a look at old moving average data and test its correlation with asset-specific prices.
These are just a few of the ways moving averages can enhance your trading strategy. These indicators usually do not (directly) contradict others, meaning that—at the very least—they can help offer a useful point of reference.
Paying attention to the moving averages of a prospective asset can help you predict which future price movements are most likely to occur. There are many different moving averages available and the formulas of these averages can be adjusted in accordance with your personal trading preferences.