Maybe you’re the type of trader that keeps metrics to make important life decisions?
If you fit the description, you may want to add moving averages to your aresenal to discover just how much they can improve your trading strategies.
Not sure where to begin? Moving averages are a useful tool for tracking the direction and strength of a trend by capturing specific price data points over a specified period of time (as defined by the timeframe you are looking at) to constantly update the average price as it moves along the chart.
Indeed, the position of the moving averages depends upon the nature of the asset you are looking at.
Generally, when prices are below a particular moving average, it signals to traders that the price has lost momentum and the trend has turned bearish (meaning price and sentiment are trending down).
Conversely, if prices are above a moving average it can generally be considered bullish, as long as prices remain on top and have the backing from other indicators such as the Stochastic Oscillator or Relative Strength Index to add to your layers of confirmation.
Simplifying your averages
A good introduction to moving averages and your journey to understanding the basic concepts begins with the simple moving average, which is calculated by taking the mean of a given set of values and plotting it on the chart.
For example, let’s say you were looking at a simple 5-day moving average. You take the closing price of each day, add those values then divide by the number of days, in this case, 5.
It would look something like this:
5, 2, 3, 5 + 4 + 9 + 7 + 5 / 5 = 6 ← Ignoring previous datasets from past days and taking only the recent 5 sets, hence the term moving average.
The average result of 6, takes into account the previous 5 data points and provides a general idea of how an asset is priced relative to the last 5 days.
Take bitcoin’s recent move for example. The blue line mapped on the chart is the simple moving average representing 5 days or 5 sets of data points.
We can assume, at least in the short-term, that prices turned bullish as the blue line passed underneath the close on August 16 and remained so when prices broke another $100 higher.
We can also spot when prices began to turn bearish back in July as the line moved above the candlesticks’ closing periods, signaling to traders a bull-to-bear trend change and a loss of momentum for any further upside action.
As prices dipped below the line, the bulls were unable to ‘break’ above it and a short-term downtrend ensued lasting 16 days until prices shifted back above, signaling once more, a change in the short-term trend.
The most common periods used amongst traders are the 50, 100 and 200 averages as these have proven and predictable results due to their ability to collect a larger portion of data points.
However, there is no perfect solution for your simple moving average setup, analysts usually devise their own strategies, often employing multiple moving averages in order to provide greater understanding and depth to their analysis.
In time you will get to know each type of moving average and their various uses but for now, you should familiarise yourself with the simple moving average, experimenting on different timeframes to see how each chart reacts.
Image via Shutterstock; Charts via TradingView