Technical analysis is a major method of trade analysis used by crypto traders and investors to understand market information and make more informed trading decisions. One of the major indicators used in technical analysis is the moving average. Understanding how moving averages work will better inform you about market movements. So, let’s quickly look at how the moving average works.
What Are Moving Averages?
Moving averages (MAs) are technical indicators used to track and evaluate an asset’s performance over a specific period. They smooth out price movement to get a clearer picture of the market trend. MAs are not only used in crypto trading; they are used across various financial markets, like the stock and forex markets.
Like other trading indicators, moving averages can generate buy and sell signals. For instance, a shorter (faster) MA crossing above the longer (slower) MA is a bullish signal. On the other hand, if it crosses below, traders take it as a bearish signal. Expert traders use moving averages with other indicators to get more accurate signals and trade entry positions.
Types of Moving Averages
The two most commonly used moving averages are the simple moving average (SMA) and the exponential moving average (EMA).
Simple moving averages and exponential moving averages basically do the same thing. Both provide average price data, with the main difference being how they are calculated.
The simple moving average is the calculation of an asset’s average price, usually the closing prices over a number of periods. Since it analyzes closing prices, it does not react quickly to market happenings.
The exponential moving average analyzes recent price moves more than the older ones. It is also more complex in its calculation than the simple moving average. However, you won’t need to know how to calculate them since the trading platform carries out the calculations automatically.
Whether to use SMAs and EMAs depends on your trading strategy. The EMA may be a better option if you want to make quick decisions based on the moving average slope. However, since it reacts faster to price, you will likely enter bad trades due to false signals. SMAs, on the other hand, can be slow in providing you with trade signals, and relying solely on them can make you enter trends late or even miss trade entries. EMAs and SMAs provide better results when combined with other indicators.
How to Trade With Moving Averages
Both short-term and long-term traders use moving averages to track market direction and trends. The most commonly used averages are the 5-day, 10-day, 20-day, 50-day, 100-day, and 200-day moving averages. Traders typically focus on five to fifty-day MAs to check for short-term to medium-term market trends, while they use the 50-day MA and above to check for medium-term to long-term trends.
A trader who trades on long-term (higher) timeframes can use the MA to check for short-term trends within a higher timeframe. Also, a day trader or scalper who focuses on the lower timeframes can also use the higher moving average to check for long-term trends within the lower timeframes.
Consequently, using a 100-day moving average period on a 15-minute timeframe implies that you are checking a long-term trend in a short timeframe. On the other hand, checking a ten-period MA on a four-hour chart will show a short-term trend in the four-hour timeframe (a higher timeframe).
Using Moving Average Crossover
A moving average crossover can be explained as a moment whereby one moving average crosses over another. This crossing indicates a change in market trend.
Hence, the moving average crossover can be either bullish or bearish. A bullish crossover, otherwise known as a “golden cross,” occurs when the shorter period moving average crosses above the longer period moving average. Conversely, a bullish crossover, also known as a death cross, occurs when the shorter moving average crosses below a longer-term moving average.
For instance, if a 50-day MA crosses above a 200-day MA, it shows that the bulls have taken over the market, and traders start to look for buy signals. In contrast, a 50-day MA crossing below a 200-day MA signals that the bears are in control, making traders search for selling opportunities.
Moving Averages as Support and Resistance
Moving averages can act as support and resistance for prices. For instance, when the market price is above the moving average, it can find support there, and the MA can also serve as price resistance when the price is below it.
When the price bounces off the moving average, traders look for ways to execute trades in the market by using price action or other tools and indicators. When the MA serves as a support, traders look for buying opportunities, and when it is a resistance, traders search for selling opportunities.
Using Moving Averages With Trend Line
Many traders don’t use the moving averages alone; they use them with other tools and indicators to achieve more accurate analysis. One such tool is the trend line. Traders use the trend line with moving averages to know how likely support or resistance would hold the price.
If the moving average forms a confluence with the trend line to give price support or resistance in a trending market, then such support or resistance is assumed to be strong.
Limitations of Moving Averages
A common drawback of moving averages is that they are lagging indicators; they respond late to price action. Thus, traders who rely on them often enter a market trend late and sometimes even miss out on trades. In addition, MA works better in a trending market. Thus, if an MA is used for a non-trending market, it might give the wrong signal.
Like many other technical indicators, the information obtained from the MA is only based on previous market prices. Therefore, the indicator does not consider many other external and fundamental factors that could affect market prices but focuses on previous price information.
Moving averages are better used as a part of your trade analysis, and their information should not be used as the sole determinant of your trading decisions. MA shouldn’t be used alone; you can use them with price action and other technical indicators.
Practice Before Taking the Risk
Before relying on any technical indicator, make sure you properly backtest it. Not properly backtesting a strategy before using it is like jumping into a swimming pool without first learning how to swim; there is a high chance you will drown. You can also practice paper trading as it gives you a live trading experience in a simulated environment.