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Moving averages are among the most popular technical analysis indicators used by equity traders. However, deciding on the best moving averages for trading stocks depends on the instruments being traded and the preferences of the major players in the market. Moving averages are popular among day traders because they make the price movements of the market clearer and offer a simple way to spot trends and trading opportunities.
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Types of Moving Averages
The most popular moving averages are the: simple, exponential and weighted moving averages. There are others like the triangular, Wilder’s Smoothing, end point and time series, but they are beyond the scope of this article and are not of particular interest to most traders because of their tendency to introduce a lot of noise into the indicator. Here are the three that are generally considered to be the best moving averages for trading stocks:
Simple: A simple moving average (SMA) measures the average price over a specific time frame. For example, a 5-day simple moving average is the sum of the last 5 days closing/opening price divided by the number of time periods (5). In essence, simple moving average gives equal weighting to all periods in the sample data.
Although you can use more time periods in the moving average, the more periods that are included in the analysis, the less emphasis there is on the more recent trading action. This happens because a simple moving average gives equal weight to each trading period, which causes SMA to respond slowly to price fluctuations; this is why it is referred to as a lagging indicator.
Exponential: Traders tend to prefer the exponential moving average (EMA) because it is faster than the SMA in responding to the latest price action. Exponential moving averages have less lag because they put more weight on the most recent prices. As a result, they will more quickly, confirm a change in the market’s trend or signal a trade entry than would a SMA. Consequently, traders regard EMA as the best moving average for short-term trading.
While it is true that the exponential moving average is faster than the simple moving average, one must remember that it can also cause more false entry and exit signals.
Weighted: This is another flavor of the exponential moving average but it gives even more weight to more recent prices to make the technical analysis indicator faster. This introduces more noise than the simple and exponential moving averages but it is quicker at confirming trades.
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How to Trade Using the Moving Averages
How to Trade Using the Moving Averages
Moving averages work well in bullish or bearish markets, but can cause some trouble when the market starts to consolidate or becomes range bound. Moving averages tend to create many false signals when the market is flat. Unfortunately, these false signals are often given before the trader realizes that the market has started to consolidate. Which is why it’s not a good idea to use moving averages by themselves; other indicators should be used to filter the bad signals and confirm good entries. However, moving averages can be used when:
- Identifying price breakouts;
- Identifying Support & Resistance levels; and,
- Identifying a trend
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Moving Average Trading Strategy
Moving Averages can be used to identify or confirm an up-trend market when the moving average line is rising and prices remain above the moving average. This can be further confirmed when a shorter period moving average crosses the longer moving average in an upwardly direction and vice versa.
However, the most common moving average trading strategy is that of using a small time frame MA (fast moving average) with a larger time frame MA (slow moving average), i.e. a 100 EMA with a 20 EMA. A trade signal is given when the fast MA crosses the slower MA (see figure 1). It is important that the market trend be confirmed prior to entering a trade. This can be done by checking a weekly or monthly chart to confirm what direction the market is going. This is important because it’s just harder to make money when you are going against the trend.
Some of the more popular moving averages for trading stocks include:
- 200 SMA, 144 EMA (to identify the longer-term trends)
- 20 EMA and 10 EMA for entry signals
The 144 EMA is derived from the Fibonnacci sequence and the others are just generally accepted values that most traders use. For example, you will often here reputable trading professions speaking about a particular instrument finding support on a 100 EMA line or breaking the trend by crossing a 200 EMA. It is recommended that you use these technical analysis indicators because most traders use them and it’s generally better to run with the herd.
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Moving Averages in Flat Markets
No indicator is perfect and this is certainly the case with moving averages, especially in flat markets. As we said earlier, MA are useful for spotting trends, establishing support and resistance levels and finding trades, but when the market becomes flat, moving averages are notorious for giving bad signals. Moving averages are most dangerous when the market is just entering a consolidation area because it will give several bad signals before the trader realizes that the market is consolidating (see figure 2).
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Forex and stock traders alike are on the constant lookout for tools and technical analysis indicators that can accurately tell them when to buy and when to sell. Moving averages are popular among day traders because they smooth out price fluctuations and give clarity to the market’s price action.
However, traders must be careful not to use moving averages by themselves, but also use another indicator to confirm what the moving average is indicating. Regardless, almost every trader uses some form of the moving average, be it a SMA, EMA or WMA. But the best moving averages for trading stocks are generally thought to be the 10, 20, 100 and 144 variations of the SMA and EMA.