What are moving averages? Measure market trends

How can you determine the direction of an asset’s price trend? If you want to determine whether price is rising, falling or moving sideways, you will find that it never moves in a straight line. Prices rise and fall, take small steps or make great leaps.

Perhaps the best way to measure a market trend is to “smooth” the price movements by averaging them and observing their gradual changes. This makes the moving average indicator an effective tool for measuring trends. This prevents you from being distracted by the volatility inherent in price changes, while showing the market’s relative direction.

What is a moving average and how is it constructed?

In technical analysis, a moving average is a calculation of successive prices of a given asset averaged over a period of time. We start by “averaging” prices over a number of days. That average will change, or “move”, after each successive day (hence the term “moving average”).

Let’s construct a three-day moving average of volatile price movements over a six-day period:

Day 1: $10 Day 2: $9 (small drop) Day 3: $14 (that was a big jump) Day 4: $12 (another drop) Day 5: $20 (another big jump) Day 6: $15 ( a big decrease)

If you are only focused on daily price movements, it can be difficult to tell whether this asset is moving up or down, simply because it jumps in both directions.

But if we smooth the prices with a three-day period, we can get a clearer idea of ​​the average direction.

While the daily closing prices seem to be jumping in all directions, the three-day moving average shows a steady upward trend from $11 to $16. Again, this is what moving averages are designed to reveal – the underlying trend of price movements.

The big caveat here is that different moving average periods will give you a different trend reading. Some trends will move faster or slower, and there are cases where downtrends and uptrends can exist simultaneously, depending on the time frame you use.

Use moving averages to identify price trends

In the example above, we highlighted a three-day moving average for the sake of simplicity. In reality, three days may be too short a period for most investors to find useful. Two principles apply here:

Use shorter moving averages to measure short-term trends and longer moving averages to gauge longer-term trends. The shorter term the moving average is, the closer it is to the underlying price movement, and the more volatile its trend will appear.

It is important to understand these two ideas. Otherwise, things can get messy on a price chart. For example, let’s try to plot the 3-day, 5-day, 10-day and 20-day moving averages against a longer-term 100-day moving average. (See figure 1.)

Figure 1: THE TREND IS YOUR FRIEND, BUT DEPENDS ON WHICH TREND. Depending on how many time periods (days, hours or weeks) are in a collection period, the moving average can give a different signal about the direction and momentum of a trend.

Barchart.com. Notes: Encyclopædia Britannica, Inc.

Instead of a clear trend, what you see in Figure 1 is a rainbow of tangled price spaghetti. The different time periods show conflicting trends that can be confusing for most investors (although they can be useful for traders who want to see where different trends converge and diverge).

To keep things simple, let’s take a closer look at two of the most commonly used moving averages: the 50-day moving average and 200-day moving average.

The two most common moving averages for investors

Many investors follow the 50-day and the 200-day moving averages. The 50-day tends to give a good picture of the intermediate trend, while the 200-day helps investors see the longer-term trend.

Figure 2: IT’S ALL RELATIVE. Comparing the price action of the 50-day moving average to the 200-day MA can give you an extra layer of information, as well as levels of price support and resistance.

Barchart.com. Notes: Encyclopædia Britannica, Inc.

In a bullish market, the 50-day moving average is generally considered support. This means that if an asset pulls back from an uptrend, buyers can enter the market at the 50-day level, causing an asset’s price to bounce back and resume its uptrend. In contrast, a close below the 50-day can be seen as bearish and may prompt buyers (or short sellers) to sell the asset.

Although the 200-day moving average can also be considered long-term support, it may not provide regular signals because prices (in a rising market) typically remain well above this longer-term average.

The combination of the 50-day and 200-day moving averages

If you combine the 50-day and 200-day moving averages, the pair can make a strong technical indicator. Here’s how investors typically use this combination:

When the 50-day and 200-day move in the same direction, it indicates a strong trend (up or down). When they move in different directions (eg one moves up or down and the other is flat), it indicates a weakening trend or a potential trend change. When the 50-day MA crosses below the 200-day, it is called a death cross and is considered bearish. This indicates that the market may be headed for a longer-term downtrend or bear market. When the 50-day crosses above the 200-day moving average, it is called a golden cross and is considered bullish, especially in a bear market. This suggests that the market may be headed for a longer-term uptrend or bull market.

Different types of moving averages

The moving average examples we just discussed are the most basic type – hence the term simple moving average (MA or SMA for short). There are many other moving averages you can use. Two of the more common variations are the exponential moving average (EMA) and the weighted moving average (WMA).

These and other moving average variations are designed to be more (or less) responsive to recent prices. They can spin faster or slower depending on which type you use.

Traders who use moving averages to help guide market entries and exits may prefer more or less responsive moving averages depending on their trading approach. For example, if you tend to get in and out of the market quickly, you may prefer a moving average with fewer collection periods and/or a weighted average that moves to the most recent data. On the other hand, if you are more big-picture, long-term oriented, you may prefer to track trends with the 200-day moving average.

The bottom line

Using moving averages to measure price trends is a mixture of art and science. Moving averages can help you monitor the direction of a trend, but their effectiveness depends on which time period(s) you choose or combine. For example, you may see a definite trend when looking at a medium-term moving average, but see the complete opposite trend (or no definite trend) when looking at a shorter or longer-term average.

Curious? Try it yourself by trying different moving averages on a price chart, and you’ll get a better idea of ​​how things look from different time periods vantage points. Eventually, you will figure out which one is best compatible with your investment strategy.