Breaking Down Moving Averages

Breaking Down Moving Averages

| Rich B. Clifford | Blog
While many technical indicators are nothing but mumbo-jumbo, moving averages are so widely accepted they’ve become a self-fulfilling prophecy that all traders have to be aware of. But many traders make fatal mistakes when they start using moving averages, so we’re to help you see them for what they are – and what they aren’t.

The Two Kinds of Moving Averages

Simple Moving Average: an average of the last X number of trading periods, typically days. 10-day, 50-day, and 200-day SMAs are common.

Exponential Moving Average: an average of the last X number of trading periods, weighted so that recent prices have greater significance. Traders often use 10-day, 21-day, and 50-day EMAs, and shorter time periods are more common than with SMAs.

The main difference is that EMAs are more volatile, while SMAs respond to new price data more slowly. (We won’t bore you with the math, but you can always look up “Comparing EMA and SMA” if you’re in for some number-crunching.) As a result, the EMA is more suited to day trading because it more heavily weighs recent trends, while the SMA is more suited to swing trading, because it indicates fewer trends.

As simple as they are, moving averages continue to work, largely because they’re so popular with traders worldwide. Big moving-average events in major indices and bonds are a constant source of headlines in financial news. So, while you don’t have to trust them to make a trading decision, you absolutely have to be aware of them: everyone else is.

Moving Average Periods: A Popularity Contest

Building off of the point above: moving averages only work when you stick to the most commonly used moving average lengths, also called periods. That way, the trends that you’re seeing are the same trends that other traders and algorithms are basing their trades on.

Popular EMA Periods for Day Trading

  • 9 or 10 period: Very popular and extremely volatile. If you do intraday trading, this one’s essential.
  • 21 period: The medium-term forecast for day traders. This is your sweet spot for figuring out big weekly moves.
  • 50 period: Long-term, in the world of day trading. A crossover of the 21- and 50-day moving averages is often a strong signal.

Popular SMA Periods for Swing Trading

  • 50-day: The standard swing-trading moving average. Neither short-term nor long-term, it points out unusual activity well.
  • 100-day: A medium-term benchmark. Not as popular only because 50-day/200-day convergences are such strong indicators of how short- and long-term trends are lining up.
  • 200- or 250-day: 200-day averages are the go-to for identifying long-term trends in virtually every market. 250-day moving averages are also a nice, round number, indicating about one year’s worth of trading days.

How to Use Moving Averages

Always keep in mind that moving averages are not a commandment telling you to buy or sell now. They’re a filter, and should be treated as just one layer of your trading strategy. Use them to filter out information and focus your attention on significant upswings and dips.

As an example, perhaps you’ve been following a stock closely for months, buying regularly as it climbs 25%. One day, you wake up to a sudden 5% drop. On the surface, this may sound your alarm bells: the trend looks like it’s reversing. But then, you check the moving averages and find today’s price is still above the moving average, i.e. the sudden drop wasn’t strong enough to break the trend, and is most likely just a small correction in response to the stock’s recent gains.

Just the occasional pause like this can prevent you from making short-sighted trades – another way moving averages can prove valuable.

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