What is the moving average and how do you trade with it?

What is a moving average?

A moving average (MA) is a technical indicator that can be useful in determining the future direction in a market. It does this by combining certain price points of the asset and then dividing that sum by the number of data points over a specific period - ultimately helping you to spot a possible trend.

Traders and investors generally use the historical data of price movement to spot a trend pattern, identify an entry and exit point to lessen the impact of random price fluctuations in a market. You can analyse the levels of support and resistance in a market by looking at the price charts to generate trading signals over a given time frame.

The term ‘moving’ average is derived from the replacement of old figures with new price points, changing the direction of the trend line on the chart every time. It is also known as a lagging indicator because it trails the price action of an asset over a specific period, smoothing out the price fluctuations to better spot the trend from the usual activity in the market.

This enables technical analysts to use the indicator when assessing short- and long-term timeframes to determine possible future patterns. For example, when trading finite commodities such as the US Crude, its price can see massive fluctuations due to supply and demand changes.

With us, you can use the MA indicator to analyse changes in price points on a custom date range, such as 20-, 50-, 100-, 200-day period before you take a position.

Types of moving averages

The two most popular types of moving averages are simple moving average (SMA) and exponential moving average (EMA).

Simple moving average

A simple moving average is an unweighted technical indicator that combines the most recent data points to determine the mean price and divide the sum by the number of time periods in the past.

Once you’ve determined the mean over a given period, you’ll divide it by the number of prices in the set. You can calculate the simple moving average of an asset’s price by following the formula below:

For example, if you track the price of an asset over the last five data points using simple moving average (ie 67, 68, 65, 67 and 68), you’d combine all the values and divide them by five (n) to get the average of 67.

Exponential moving average

An exponential moving average is an indicator that places more significance on the most recent price points of an asset when determining future direction, making the indicator responsive to new information. It’s different from simple moving average because SMA measures data sets from the past, and EMA tracks the latest price point to provide trading signals on the direction that the market could take next.

Traders and investors tend to use the EMA indicator, especially in a highly volatile market because it’s more sensitive to price changes than the SMA. For example, EMA considers the most recent price points that could be a result of company’s performance, changes in management, market sentiment or unexpected events.

Using the latest price point, you can measure the average closing price of a security over a specified number of periods, such as a 20-day, 50-day or 100-day average. You can calculate the exponential moving average using the formula below:

Let’s say you chose an EMA taken over a short timeframe such as 10-day average. You’d calculate EMA by first getting the current closing price (Pt), the EMA of the previous period (EMAt-1), and the smoothing factor (k).

The smoothing factor (k) takes on a value of between 0 and 1, using the formula 2/(m+1), where m = 10.

How to start trading using moving averages

You can use the moving average indicator to trade with us. When trading, you’ll take a position on a financial asset’s price rising or falling without taking ownership of the underlying. You’ll use derivative products like CFDs to go long if you believe that it’ll rise or short if you think that it’ll fall.

We’ve listed a few steps that you need to follow to open a position with us:

1. Choose your preferred market
2. Create a CFD account or practise on a demo
3. Set your position size and manage your risk
4. Open your position and monitor your trade

CFD trading

CFD trading is buying and selling contracts to exchange the difference on price from the point at which the contract is opened, to when it’s closed. This derivative product can also be traded on leverage, which means you have to take steps to manage your risk.
Some traders prefer CFDs because in some territories they’re a great hedging tool to offset any losses against profits for capital gains tax (CGT) purposes.¹

Discover what CFD trading is and how it works

Moving average strategies in trading

There are several moving averages strategies that you can use to trade with us

1. Moving average crossover strategy
2. Moving average ribbon strategy
3. Moving average convergence divergence (MACD)
4. Bollinger bands moving average strategy

Moving average crossover strategy

The moving average crossover strategy occurs when two different moving average lines intersect with one another to signal an opportunity to buy and sell. When this happens, the price level of the shorter-term moving average crosses either above or below the longer-term moving average to signal a potential change in trend line.

The short-term moving average is also considered the faster moving average because it measures prices over a shorter time frame like a 5-, 10- or 20-day period. This makes it more responsive to daily price changes.

The long-term moving average, on the other hand, is much slower and less sensitive to short-term price actions because it considers prices over a longer stretch of time like 100- or 200-day period. You can use these price levels to spot trend patterns, as well as the entry points to take a position and exit before the trend ends or reverses to the mean.

For example, when the short-term moving average (50 MA) crosses above the long-term moving average (200 MA) – also known as the golden cross – it signals that the asset price might rise and you should buy. Conversely, if the short-term moving average crosses below the long-term moving average – referred to as the death cross – it means that the price may fall, and you should consider selling.

Find out more about moving average crossovers strategies

Moving average ribbon strategy

A moving average ribbon is an adaptation of the crossover strategy in which a series of moving average trend lines are added onto the same chart in sequential order, to resemble a ribbon.

Generally, the moving average ribbon is created using six to eight lengths that display different trend lines, separated in 10-period intervals. For example, you’d add date ranges starting from 10-, 20-, 30-, 40-, 50-, and 60-day moving averages.

Note that you can calculate the moving average ribbon using SMA and EMA. To interpret the moving average ribbon, you’ll look at the direction that the trend lines are moving. For example, if the MA lines are moving in the same direction, this signals a strong trend. This would be MA lines in all time frames moving either upward or downward in the ribbon.

Traders and investors also measure the width between the MA lines to determine the momentum of the trend. For instance, let’s say the ribbon that the MA lines create moves parallel to one another, then that’d signal a strong trend.

However, if the MA lines form a ribbon with the lines growing farther apart from each period interval, this occurrence means that the current trend is coming to an end. Alternatively, if the MA lines are drawing closer together to the point where their crossing, this can indicate the start of a new trend.

Moving average convergence divergence (MACD)

The moving average convergence divergence (MACD) is a technical indicator that identifies changes in a market's price momentum. The indicator gathers data points from different moving average lines to determine support and resistance levels.

There are three components that are taken into consideration when making up the MACD indicator: the MACD line, signal line and the histogram. Here are some of the calculations you need to consider:

• MACD line = 12-day EMA of closing price – 26-day EMA of closing price
• Signal line = 9-day EMA of MACD line
• Histogram = MACD line – signal line

You can use the indicator to determine the strength of the trend and the turning point of the trend. For example, when the MACD line crosses above the signal line, it indicates that you could buy the security, and if the MACD line crosses below the signal line, it indicates that you could sell or short the market.

Learn about moving average convergence divergence (MACD) strategy

Bollinger Bands moving average strategy

Bollinger Bands are used by technical analysts to plot trend lines on a chart that display oversold or overbought levels. The two levels are on either side of the simple moving average line, two standard deviations away from the SMA of the asset’s price.

Traders and investors use the tool to measure the volatility in a market. That is, if the bands are further away from the middle line, it means that a market is more volatile, while the closer the bands are signals a more stable market.

The calculations involve taking the band on top of the middle (SMA) band and adding twice the daily standard deviation to that amount. The band below the middle band is subtracted two times the daily standard deviation.

One of the interpretations of using the Bollinger Bands is tracking the number of times that the market touches the bands to spot the signal to buy or sell. For example, if the price touches the band above the SMA line, it’ll provide an overbought signal. However, if the current price touches the band below the SMA line, it indicates an oversold signal.

Explore the ins and outs of the Bollinger bands

Moving average summed-up

• A moving average is an indicator that combines several price points and divides them by the number of data points available over a given timeframe to produce a trend line
• The two most popular types of moving averages are the simple moving average and exponential moving average
• The SMA adds the most recent data points over a specific period and divides the sum by the number of time periods in the past to provide signals for future price direction
• EMA applies an increase weighting to more recent price data, whereas a SMA places an equal weighting on price data
• There are several moving average strategies that you can use when trading, including the moving average crossover, moving average ribbon, MACD, and the Bollinger Bands

Footnotes
¹ Tax laws are subject to change and depend on individual circumstances. Tax law may differ in a jurisdiction other than the UK.