Regarded by many as the oldest, lamest trick on the book — Moving Average — yet it identifies the trend precisely and remains contemporary. However, it can get you chopped in a choppy market. So, the tricky part is knowing when to embrace the moving averages, SMA and EMA, and when to let go.
What is a Moving Average?
Moving average is a lagging indicator which smoothens the past price action, filters the noise and decodes its complexity.
It doesn’t predict the trend. Instead, it merely identifies the trend.
Why is it important?
In any field, be it sports or finance, the average performance matters.
When an asset outruns its average performance, it enters a bull phase.
Likewise, if it falls short of its average, it enters a bear phase.
But, the alluring part is, you can pick, choose and define the trend from a broad spectrum of averages, say 100 SMA, 200 SMA, 20 EMA, or any value.
Also, the definition of trend varies from analyst to analyst when it comes to moving average. For example, you are using 100 SMA and your friend is using 200 SMA to define the trend. Suppose, the market is above the 100SMA but below the 200 SMA, then you interpret the trend as bullish whereas for your friend it is in a bearish phase.
Although the opinions contradict each other, both are correct. It is just that you are referring to the short-term trend whereas your friend defines the long-term trend.
If the concept of various trends existing in the same asset seems gloomy to you, get to know more about the various degrees of a trend with the Elliott wave.
Types of Moving Average
Although there are three types, trading fraternity uses only two types of moving averages
- Simple Moving Average aka SMA
- Exponential Moving Average aka EMA
- Linear Weighted Moving Average – The least used
In this article, we’re going to focus only on the first two types that aid your trading.
Simple Moving Average
As the name suggests, it is the purest form of moving average.
It is just the arithmetic mean of a specific period.
It smoothens the price action and is not susceptible to noise.
Hence, SMA best suits for long-term trading rather than short-term trading.
In a long-term trend move, the SMAs like 100 or 200, usually act as a strong support or resistance.
A trader enters a buy trade (in an uptrend) whenever the asset pulls back to the SMA, hoping the SMA to lend support to the trend.
When the price diverges and is far-fetched from the moving average, the trader closes out his position anticipating a retracement.
Take a look at the above candlestick chart. Once the 200-day SMA breaks, an avalanche of sellers pounce in on the asset, flushing it down. When the gap between the moving average and price widens, it invites a profit booking rally, pulling it towards the SMA. Upon reaching the SMA, a new sell rally initiates.
Likewise, when the pair crossovers above the 200-SMA, the same cycle repeats, only this time in the opposite direction.
Know more about moving average as support and resistance indicators here.
Exponential Moving Average
The exponential moving average gives weight to the recent prices over the older ones. Hence it identifies the short-term trend precisely rather than longer-term trends.
The widely used EMAs are 8 and 21 to identify the momentum of the asset.
The trading strategy with the EMA is similar to SMA.
A trader buys the asset when the asset crosses an exponential moving average from below and closes out when the gap between moving average and price widens.
In the above USD/JPY 4-hour chart, the 20-EMA acts as critical support. Each time it retraces, 20-EMA holds guard and revamps the trend. And when it breaks, the asset plunges indicating its significance.
Applications of the Moving Average
There are three types of traders in the market. The first category likes, loves and worships moving average and henceforth builds a strategy around it, say crossover strategies.
The next group gives due credit to it but doesn’t take any credit from it. They merely use the averages to feel the pulse of the market and doesn’t use it as part of their strategy.
The last group merely hate both the SMA and the EMA.
All these groups have their reasons and justifications. It follows next.
When one serves you right, why not use two!
Traders use two moving averages simultaneously on the charts – one short term and the other comparatively longer, say 5 SMA and 50 SMA.
When the short-term average crosses the long-term average from below, it’s a bullish crossover.
Likewise, if the crossover happens from above to below, it’s a bearish crossover.
The analyst by virtue of his/her experience chooses the pair of moving averages.
Even an EMA and SMA are paired together to form a crossover strategy. In this case, the EMA usually assumes the role of the short-term moving average.
The above image is a 15-min chart of the USD/CAD in which the 3 EMA and 12 EMA are the short and long-term moving averages respectively. The bullish and bearish crossover presents trading opportunities. Since the strategy is formulated with an exponential moving average, it offers multiple signals within a quick timeframe but with low yields.
The popular SMAs are 50,100 and 200.
Hence a crossover between these moving averages is a sanctity to the trading fraternity.
When the 50 SMA makes a bullish crossover over the 100 SMA or 200 SMA, it is the Golden Cross. And the asset flies off to the highs, more often than not.
Likewise, a death cross, which is the bearish crossover of 50 SMA over 100 SMA or 200 SMA, ensues a big sell-off in the counter.
In the above chart of GBP/JPY, the 50 SMA crosses the 100 SMA from above. Initially, the price limpers upside for a corrective rally. However, after some consolidation, the price plummets 6500 pips, which is a rarity. The death cross took the bulls to the cleaners.
Moral: SMA is a slow starter, but they do cover up with long legs in later part of their innings.
Verdict: When it helps you in the short term and long term, you can’t help but love it.
Most traders use 100 SMA and 200 SMA merely to interpret the market sentiment. And for trade decisions, they use indicators like Relative Strength Index or chart patterns.
This tactic is not only confined to higher time-frames but also renders the same performance in the smaller time-frames, say 4-hour, 1-hour or 15-min.
The 100 SMA usually prove to be an excellent indicator of the short-term trend. And it doesn’t let the price to pass through that easily.
In the above chart, the price forms an inverted head and shoulder pattern. Since the 100 SMA was already broken, a trend reversal is obvious. And a moving average fan might take an advance buy position while the right shoulder was being built. Though it is an aggressive entry, it is done with the backing of a moving average and so it proves out to be a meticulous trade.
Later, the pair consolidated in a tight range in the form of a triangle pattern, which is a continuation pattern more often than not. Hence a trader could hope for a bullish breakout courtesy of 100 SMA.
In both cases, the SMA was not the stimulant but a catalyst.
Moral: Skew to the catalyst version of the moving average, if at all the stimulant.
Verdict: Need of the hour.
Moving Average – Wreaking havoc
If you’ve come this far, then moving average seems like a golden ticket to you.
But to be fair, like every technical analysis tool, moving average has its share of flaws and criticism too.
Its performance in the sideways market is certainly a turn off to traders.
Markets do exist in range bound movement for longer durations, and if one uses moving average during such instance, it’s a suicide mission.
Look at the above chart, a moving average fan would have a gruesome experience, albeit using two averages.
Both 50-SMA and 20-EMA does not provide any impetus for trades. The price hovers merely around it as if it doesn’t exist.
A retrospective analysis might let you ponder on what could’ve been done, but in real-time, things would have been eerie.
But traders do overcome the debacle of the sideways market by using Bollinger Bands. It is nothing but a moving average along with standard deviations. To know more about Bollinger Bands and its application in the sideways market, read here.
Another criticism the moving averages face is that they provide an entry point but not an exit. So a trader might hold it long enough only to see the price retreat back to the entry point and exit out of panic. Or miss out a good chunk of profits by exiting early.
Should you choose SMA or EMA?
Technical analysis is more of an art than science. And so, there is no rule book to guide the traders.
Hence a trader should not hesitate to try out different methods and strategies.
But one should have a proper understanding of the basics to try out experiments.
Albeit technological advances which paints moving average on your charts instantly, it is still vital to know the intricacies of their calculations.
Calculation of SMA
The simple moving average is the arithmetic mean of numbers.
The summation of all the numbers and dividing it by the period value gives the moving average.
As indicated in the above image, although the asset has moved to the value of 80’s, still the SMA prints the data in the 60’s.
The time lag is considerably high. Also as the period increases, say 50, 100, 200, it only gets worse.
So, you’re vulnerable to make a trade decision with obsolete data. Or miss out an entry point owing to the lagging effect.
And, if you’re of the type, who don’t like to miss a single pip, then SMA fails you, big time.
Calculation of EMA
To overcome the lagging effect of SMA, exponential moving average lets the recent closing prices influence it over the age-old, outdated price action.
It multiplies the latest closing prices with a ratio, smoothing factor.
The calculation of EMA is a bit complicated, and you’ve to rely on the systems.
But we have simplified it in a formula for you.
Note: For the calculation of the first leg of EMA, substitute ‘previous EMA’ with SMA of the first 10 periods.
For the same set of values, EMA prints a value of 70.9621.
On comparison with SMA, the lag reduces by more than 30%, which is a sizable value.
But here’s the catch, what if it’s a false breakout and the value retreats in a short span. In this case, you’re vulnerable to trap.
The smoothing factor is a critical aspect of the exponential moving average.
Since the numerator value is 2, it literally means that every time the period doubles, the factor halves. It, in turn, implies that the lag compounds as the period increases.
Hence, short-term EMAs prove to be effective over long-term EMAs.
Also, it is the reason that crossover tactics work better in the short-period EMA since the lag factor pulls the longer period EMA down.
Verdict – SMA vs. EMA: Your priority takes precedence.
Moving average is a tool of technical analysis. And it doesn’t come with a user manual. So, set aside your inhibitions and feel free to experiment and come up with new interpretations and theories.
There are innumerable combinations of SMA and EMA available for free to bring forth new strategies. However, the implication of the sideways market is a menace and you need to either overcome or dodge it, to make it as your golden ticket.
Remember, technical analysis is an art and moving average is certainly a centerpiece in it, if not a masterpiece.