How To Trade Using A Simple Moving Average

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How to Use a Moving Average to Buy Stocks

The moving average (MA) is a simple technical analysis tool that smooths out price data by creating a constantly updated average price. The average is taken over a specific period of time, like 10 days, 20 minutes, 30 weeks or any time period the trader chooses. There are advantages to using a moving average in your trading, as well as options on what type of moving average to use. Moving average strategies are also popular and can be tailored to any time frame, suiting both long-term investors and short-term traders.

Key Takeaways

  • A moving average (MA) is a widely used technical indicator that smooths out price trends by filtering out the “noise” from random short-term price fluctuations.
  • Moving averages can be constructed in several different ways, and employ different numbers of days for the averaging interval.
  • The most common applications of moving averages are to identify trend direction and to determine support and resistance levels.
  • When asset prices cross over their moving averages, it may generate a trading signal for technical traders.
  • While moving averages are useful enough on their own, they also form the basis for other technical indicators such as the moving average convergence divergence (MACD).

Moving Average

Why Use a Moving Average

A moving average helps cut down the amount of “noise” on a price chart. Look at the direction of the moving average to get a basic idea of which way the price is moving. If it is angled up, the price is moving up (or was recently) overall; angled down, and the price is moving down overall; moving sideways, and the price is likely in a range.

A moving average can also act as support or resistance. In an uptrend, a 50-day, 100-day or 200-day moving average may act as a support level, as shown in the figure below. This is because the average acts like a floor (support), so the price bounces up off of it. In a downtrend, a moving average may act as resistance; like a ceiling, the price hits the level and then starts to drop again.

The price won’t always “respect” the moving average in this way. The price may run through it slightly or stop and reverse prior to reaching it.

As a general guideline, if the price is above a moving average, the trend is up. If the price is below a moving average, the trend is down. However, moving averages can have different lengths (discussed shortly), so one MA may indicate an uptrend while another MA indicates a downtrend.

Types of Moving Averages

A moving average can be calculated in different ways. A five-day simple moving average (SMA) adds up the five most recent daily closing prices and divides it by five to create a new average each day. Each average is connected to the next, creating the singular flowing line.

Another popular type of moving average is the exponential moving average (EMA). The calculation is more complex, as it applies more weighting to the most recent prices. If you plot a 50-day SMA and a 50-day EMA on the same chart, you’ll notice that the EMA reacts more quickly to price changes than the SMA does, due to the additional weighting on recent price data.

Charting software and trading platforms do the calculations, so no manual math is required to use a moving average.

One type of MA isn’t better than another. An EMA may work better in a stock or financial market for a time, and at other times, an SMA may work better. The time frame chosen for a moving average will also play a significant role in how effective it is (regardless of type).

Moving Average Length

Common moving average lengths are 10, 20, 50, 100 and 200. These lengths can be applied to any chart time frame (one minute, daily, weekly, etc.), depending on the trader’s time horizon.

The time frame or length you choose for a moving average, also called the “look back period,” can play a big role in how effective it is.

An MA with a short time frame will react much quicker to price changes than an MA with a long look back period. In the figure below, the 20-day moving average more closely tracks the actual price than the 100-day moving average does.

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The 20-day may be of analytical benefit to a shorter-term trader since it follows the price more closely and therefore produces less “lag” than the longer-term moving average. A 100-day MA may be more beneficial to a longer-term trader.

Lag is the time it takes for a moving average to signal a potential reversal. Recall that, as a general guideline, when the price is above a moving average, the trend is considered up. So when the price drops below that moving average, it signals a potential reversal based on that MA. A 20-day moving average will provide many more “reversal” signals than a 100-day moving average.

A moving average can be any length: 15, 28, 89, etc. Adjusting the moving average so it provides more accurate signals on historical data may help create better future signals.

Trading Strategies – Crossovers

Crossovers are one of the main moving average strategies. The first type is a price crossover, which is when the price crosses above or below a moving average to signal a potential change in trend.

Another strategy is to apply two moving averages to a chart: one longer and one shorter. When the shorter-term MA crosses above the longer-term MA, it’s a buy signal, as it indicates that the trend is shifting up. This is known as a “golden cross.”

Meanwhile, when the shorter-term MA crosses below the longer-term MA, it’s a sell signal, as it indicates that the trend is shifting down. This is known as a “dead/death cross.”

MA Disadvantages

Moving averages are calculated based on historical data, and nothing about the calculation is predictive in nature. Therefore, results using moving averages can be random. At times, the market seems to respect MA support/resistance and trade signals, and at other times, it shows these indicators no respect.

One major problem is that, if the price action becomes choppy, the price may swing back and forth, generating multiple trend reversal or trade signals. When this occurs, it’s best to step aside or utilize another indicator to help clarify the trend. The same thing can occur with MA crossovers when the MAs get “tangled up” for a period of time, triggering multiple losing trades.

Moving averages work quite well in strong trending conditions but poorly in choppy or ranging conditions. Adjusting the time frame can remedy this problem temporarily, although at some point, these issues are likely to occur regardless of the time frame chosen for the moving average(s).

The Bottom Line

A moving average simplifies price data by smoothing it out and creating one flowing line. This makes seeing the trend easier. Exponential moving averages react quicker to price changes than simple moving averages. In some cases, this may be good, and in others, it may cause false signals. Moving averages with a shorter look back period (20 days, for example) will also respond quicker to price changes than an average with a longer look back period (200 days).

Moving average crossovers are a popular strategy for both entries and exits. MAs can also highlight areas of potential support or resistance. While this may appear predictive, moving averages are always based on historical data and simply show the average price over a certain time period.

Investing using moving average, or any technique requires an investment account with a stockbroker. Investopedia’s list of the best online brokers is a great place to start your research on the broker that fits your needs the most.

The 20-Period Moving Average As Your Only Day Trading Tool

By Galen Woods in Trading Articles on October 24, 2020

Day trading is a fast and furious game with many facets. Hence, the best approach is to keep your trading method simple to ensure effective trading. In this article, rather than adding indicators, let’s look at how to make the most out of a single indicator – the moving average.

You might think that restricting yourself to one indicator limits your analytical options. But less is often more.

For day traders looking for simplicity, mastering one versatile indicator is the way to go. And the moving average (MA) is the Swiss Army knife you want.

In particular, here, we will focus on using a 20-period moving average as a day trading tool for trend pullback trades.

No, 20 is not a magical number. It is also not the best-kept secret among successful traders.

You can use any intermediate lookback period for your moving average when you day trade. Our considerations are:

  • A long moving average(e.g., 200-period) lags too much and does not help day traders to be nimble.
  • A short moving average (e.g., 3-period) is almost like price itself and adds little to your analysis.

As for the type of moving average, we are going with exponential. But a simple moving average will work fine too.

The key here is consistency. Choose a type and stick to it. Do not keep changing the period or kind of your moving average.

This approach requires you to interpret how price action interacts with the moving average. So employing a consistent moving average is crucial.

We will explore three functions of the moving average:

  1. How To Analyze Market Context
  2. How To Find Trade Entries
  3. How To Trail Stop-Losses (Exits)

#1: How To Analyze The Market Context With A Moving Average

The market context depends on how prices are behaving.

Is price action pushing consistently in one direction? Or is the market bouncing within a price range?

Figuring out the market bias is a crucial puzzle for any trader. And to do that well requires discretion and experience.

Let’s see how a moving average can help here.

Here are some questions to help you clarify price action with a moving average.

  1. Are prices above or below the MA now?
  2. How did the market get there?
  3. Have prices been overlapping with the MA?
  4. What is the slope of the MA?
  5. Has the slope been changing often?

With these questions, you can push yourself to analyze price action with respect to the moving average. This approach is excellent for amplifying the effectiveness of a moving average.

Before we move on to the examples below, bear in mind that you should not interpret the answers to the questions above in isolation. You need to integrate them to form a holistic market analysis.

Let’s look at two examples to see how we can do that.

Example #1

This is an example with a 5-minute chart of NQ futures. It shows the first 20 bars of the session.

Let’s answer the five questions listed above.

  1. Price is now above the MA.
  2. It got there after a bounce off the MA. However, it has not exceeded the last swing high.
  3. Seven out of the past 20 bars overlapped with the MA. The bars that overlapped had long bottom tails. The bars that did not overlap the MA were all above it.
  4. The slope of the MA is positive but not overly steep.
  5. The slope of the MA turned down momentarily at two instances.

Prices were mostly above the moving average and bounced upwards from it. These signs show that the trading session has been bullish.

However, the slope of the moving average was not steep and had turned negative in two instances. So, despite the bullishness, the market was not in a runaway trend.

Example #2

Let’s review another example. This chart shows 20 five-minute bars from the ES futures market.

Again, concerning the list of questions above:

  1. The price is now below the MA. But the current candlestick overlaps with the MA.
  2. It got here following a bearish thrust in the form of an outside bar.
  3. Thirteen bars overlapped with the MA. Three bars were close to the MA.
  4. The slope is slightly negative.
  5. The slope has changed direction five times within these 20 bars.

Most price bars here overlapped with the moving average. The sideways price action was apparent.

On top of that, consider these:

  • The consecutive bars (fourth to ninth) overlapped with the MA but closed below it each time.
  • The thrust below the MA made more headway than the attempts to rise above.

If you have to choose a side, it would be bearish. Hence, overall, the market was trapped in a range with a slight bearish bias.

As shown below, the market eventually broke out into a bearish trend.

#2: Moving Average Day Trading Setups

After analyzing the market context, the next step is to look for trade setups. Trade setups determine our exact entry timing.

Let’s see how the moving average helps us with finding trade entries.

First, know that the moving average will not offer you the best entry for each trade. No indicator can do that. But it can provide you with a constructive micro-framework to help you decide.

Once you’ve nailed down the market bias, you can technically enter the market at any time. However, depending on your confidence level, you will choose entry strategies with different levels of aggression.

With the help of a moving average, you can discern three levels of aggressiveness for pullback trade entries.

  1. Before the pullback reaches the MA
  2. Right when the pullback hits the MA
  3. After the pullback crosses the MA against the trend

I picked the ES trading session below to illustrate the different entries.

The four entries in the chart above (from left to right) decrease in the level of aggression.

  1. In a strong trend, you do not expect the market to test the MA. Hence, a trend bar against the moving average is a reasonable entry.
  2. If you expect the pullback to end around the moving average, there are two ways to enter. Placing a limit order at the MA is the more aggressive approach.
  3. When you need more confirmation before taking on a position, wait for a price pattern around the MA before entering with a stop order. (Read: Candlestick Patterns With Moving Average)
  4. With a mature trend that’s prone to deeper pullbacks, consider entering only after the market breaches the moving average. In this case, wait for the first reversal after the market has fallen below the MA. Among the pullback entries shown, this is the most conservative one.

Of course, the typology above is not exhaustive. I designed it to show how you can create a price action trading system with the help of a moving average.

You can and should try to create a framework based on your market understanding and experience with using moving averages.

#3: Trade Management – Moving Average For Trailing Stop-Losses

By definition, a moving average follows the price trend but lags behind it.

Hence, in theory, a trailing stop based on a moving average has the potential to:

  • Lock in profit and;
  • Give enough room for whipsaw action.

Let’s see the moving average in action for trailing stop-losses.

Method #1: Trailing Stop-Loss With Moving Average Level

The conventional approach is to adjust your stop-loss order along with the moving average. The moving average level is your stop-loss level.

The example below shows this tactic.

  1. Adjust your stop-loss order along with the MA. You can do this manually, or program your trading platform to trail automatically.
  2. In powerful intraday trends, the MA performs splendidly as a way to lock in profits.
  3. As you can see, in this example, it captured most of the profit potential.

Although this tactic seemed ideal in the example above, it works only in swift trends with minor and shallow pullbacks. Its performance suffers when the trend consists of a series of deeper pullbacks.

When you assess that deeper pullbacks are likely, consider the alternative approach below.

Method #2: Trailing Stop-Loss With Pivots Defined By Moving Average

To keep things simple, we’ll look at an example involving a short trade. The concepts apply to long trades as well.

Guidelines for trailing stop-loss in a short trade:

  • When prices rise above the moving average in a pullback, prepare to adjust your stop-loss.
  • When the market falls below the moving average and pushes away from it, shift the stop-loss to the highest level reached during that pullback.

A chart really helps here.

Assume you are already in a short position.

  1. Once the market goes above the MA, consider tightening your stop-loss. But do not adjust your stop-loss order yet!
  2. When the market pushes below and away from the MA, adjust the stop-loss to the price level in Point 1. This is also the highest level reached by the pullback at that point.
  3. Again, this is another potential stop-loss level.
  4. Shift your stop order only when you observe a clear push away from the MA, in the direction of the trend.

Here, we are not relying solely on the moving average level. Instead, we are using the moving average to:

  • Find reliable pullbacks for trailing our stop-loss
  • Time exactly when to adjust our stop-loss

As you can see, this approach involves more price action analysis than the first one.

Conclusion: Day Trading with Moving Average

Day trading with a moving average is a simple approach for capturing intra-day trends.

More importantly, it is a valuable tool for traders learning price action.

The main reason is that you plot a moving average on the price chart itself. Hence, it allows you to observe how it interacts with price action.

When you look at a moving average, you have to look at price action as well. It does not distract you from the market structure.

Most of the concepts we discussed in this tutorial are valid for analyzing daily charts too. So please feel free to apply them beyond your intraday trading sessions.

Open a chart now, and put on a 20-period moving average.

With sufficient practice, it might be the only indicator you need.

The article was first published on 11 December 2020 and updated on 24 October 2020.

How to Use Moving Averages to Find the Trend

One sweet way to use moving averages is to help you determine the trend.

The simplest way is to just plot a single moving average on the chart. When price action tends to stay above the moving average, it signals that price is in a general UPTREND.

If price action tends to stay below the moving average, then it indicates that it is in a DOWNTREND.

The problem with this is that it’s too simplistic.

Let’s say that USD/JPY has been in a downtrend, but a news report comes out causing it to surge higher.

You see that the price is now above the moving average. You think to yourself:

“Hmmm… It looks like this pair is about to shift direction. Time to buy this sucker!”

So you do just that. You buy a billion units cause you’re confident that USD/JPY is going to go up.

Bammm! You get faked out!

As it turns out, traders just reacted to the news but the trend continued and price kept heading lower!

This gives them a clearer signal of whether the pair is trending up or down depending on the order of the moving averages. Let us explain.

In an uptrend, the “faster” moving average should be above the “slower” moving average and for a downtrend, vice versa. For example, let’s say we have two MAs: the 10-period MA and the 20-period MA. On your chart, it would look like this:

Above is a daily chart of USD/JPY. Throughout the uptrend, the 10 SMA is above the 20 SMA.

As you can see, you can use moving averages to help show whether a pair is trending up or down. Combining this with your knowledge on trend lines, this can help you decide whether to go long or short a currency.

You can also try putting more than two moving averages on your chart. Just as long as lines are in order (fastest to slowest in an uptrend, slowest to fastest in a downtrend), then you can tell whether the pair is in an uptrend or in a downtrend.

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