The moving average (often shortened to "ma" in our research) is one of the most popular indicators and is used by technical analysts for a variety of tasks:
- to identify areas of short term support/resistance
- to determine the current trend
- as a component in many other indicators such as the MACD, or Bollinger bands.
The main advantages of moving averages is firstly that they smooth the data and thus provide a clearer visual picture of the current trend and secondly, that m.a. signals can give a precise answer as to what the trend is. The main disadvantage is that they are lagging rather than leading indicators but this should not be a problem to longer term investors.
There are two main forms of moving average:
The simple moving average (as the name suggests) calculates the average price over a specified moving time period. For example, a 20 day simple moving average will calculate the average mean price from the last twenty days closing prices and so on.
The exponential moving average ("ema") also averages the last x days closes but assigns a greater weight to the more recent prices making it more sensitive to current price action and thus reducing the lag effect.
Determining short term support and resistance
The chart below shows the Nasdaq 100 index with a 50 day exponential moving average (ema).
The index is making higher highs and higher lows in a consistent manner through most of 2003 and the 50 day ema provided a good indication of where these troughs would be i.e. where to initiate trading long positions. One could of course try a slightly longer period moving average to ensure all troughs remained above the average but from experience we have found the 50 day ema does the job well.
Generating trading signals
The crossover method generates a fairly reliable automatic trading signal when a shorter term average cross above a longer term average.
In the example below we have shown 20 and 50 day ema’s for the Nasdaq 100 index. The crossover method would buy the index when the more sensitive 20 day ema (green line) crosses above the longer term 50 day ema (red line) and would sell the index when the 20 day ema crosses back below the 50 day ema.
We have marked buys with blue arrows and sells with red arrows – this rule of thumb system would have kept us in the market from approximately 1000 to around 1500.