Moving Averages (MAs)
Moving average is a trend-following indicator and is one of the oldest, simplest, and most useful tools for traders. Whereas chart analysis is subjective and difficult to test, moving average signals are objective, precise, and not open to debate. Its purpose is to help traders identify if a new trend has started or if an old trend has ended, generating specific buy and sell signals. Moving averages are represented by lines plotted on price charts, each point reflecting the latest average price. In general, they reflect the average consensus of value at a specific period of time.
A moving average adds new prices as they occur, while dropping old ones. A rising moving average shows that the market is becoming more bullish, signaling you to stay long. A falling moving average shows that the crowd is becoming more bearish, signaling you to hold shorts.
- Which data should I average?
Traders who use daily and weekly charts usually apply moving averages to closing prices. However, the construction of moving averages should be whatever works best for you. You can even add the Closing price + High + Low of each bar and divide the result by three, if you feel that this works better for you. Some people prefer to use a midpoint value, which is the result when you divide the day’s range in half.
- How long should I set the Moving Average?
After you construct the data that you will be using, you also need to choose the width of your time window:
1) Longer Averages (Slower)
- Catch longer trends
- Advantage: Have smoother moving averages
- Disadvantage: Responds to trend changes slower, can miss important reversals
2) Shorter averages (Faster)
- Catch minor trends
- Advantage: Tracks prices better; able to signal trends earlier in the move
- Disadvantage: Its average is more sensitive to trend changes and the more sensitive it is, the more likely it is to pick random “noise” and produce false signals or deviations from the main trend, also known as whipsaws.
The longer time frames work better as long as the trend continues, but a shorter average is better to use when the trend is reversing. Nevertheless, make sure you test whatever width you choose to use on your own set of data.
