How to read candlestick charts (Volume 2)
Considered as a popular technical indicator, the moving average can help you detect and identify current or emerging trends. In this article, let’s find out how to calculate the moving average and how to use it in your trading.
What is Moving Average and why use it?
The Moving Average is a technical indicator used by traders to detect emerging and common market trends. It is a mathematical formula used to find averages using data to identify trends without price aberrations. It can be applied on all timeframes and all asset classes to help understand current short-term trends and long-term trends.
How is the moving Simple Moving Average calculated?
To calculate the Moving Average, you simply add up all the price points of an instrument over a certain period and divide by the total number of price points. For example, if you want to calculate the monthly moving average over a seven-month period, add up the monthly closing values over that period of seven months.
This is the calculation method for the standard simple moving average, but multiple variants have been created by tweaking the initial formula to put emphasis on different datapoints.
What are the different types of moving averages?
Exponential Moving Average (EMA): The exponential moving average puts higher emphasis on latest prices as newer data points are weighted more than older in the calculation than older ones.
Weighted Moving Average (WMA): The weighted moving average refers to moving averages for which a differentiating weighting component is applied. In that sense the exponential average is a weighted moving average although the calculation differs. The WMA is more customizable as a different weight can be attributed to each datapoint giving the ability to give more importance to older or more recent prices over the period.
Smoothed Moving Average (SMA): Smoothed moving average is a combination of the SMA and EMA whilst smoothing out short term market movements. The advantage of the smoothed moving average is that it reduces the volatility and allows for more stability in the analysis.
Volume Weighted Moving Average (VWMA): The Volume weighted moving average is like the weighted moving average, with the particularity that the weight attributed to each datapoint is determined by the trading volume. In fact, the volume for each price point is measured against the total volume over the defined period for the moving average calculation. This makes for higher weighting for high volume datapoints and lower weighting for lower datapoints.
In sum, the main differences between the variants are the sensitivity and “speed” at which the lines will move due to the different weighting methods. It is important to keep this in mind whilst using the indicator and looking at the charts as they will not all be identical.
How to set up the Simple Moving Average?
Fortunately, there is no need to calculate the moving average as it is available via Bitget’s trading interface that uses Tradingview’s charting tool. To add the indicator: Click the indicator button above the chart and search for “Moving Average”. Then, click to add.
Once added, double click the line that has appeared on the chat to customise the parameters to your liking:
On trading view, the same process applies, and it is possible to further customise the indicators parameters:
The Timeframe will by default match the currently displayed timeframe, but it is possible to change it to another one to avoid using multiple charts at once. For example, trading on the 4H candle chart whilst displaying a Daily moving average.
The Length represents the number of periods that the moving average is calculated over.
The Source is the nature of the datapoint that will be used to compute the moving average. Usually, it is set to and used for the price at close but can also be changed: low, high, open…
In the Smoothing section, the method and length correspond to the type of smoothing method used and the period it is to be applied to.
What does the Simple Moving Average look like on charts?
It is important to understand the mathematical nature and smoothing impact of an equally weighted average (SMA) as mentioned previously because the visual representation will change greatly based on the number of periods selected whilst tuning the indicator. In fact, a greater number of periods will visually translate into a more stable curve/line whereas selecting a smaller number of periods will translate into a line showing more variations due to the potential higher impact of each new price point.
Three simple moving averages have been represented below to showcase the difference between the 200, 100 and 50-day moving averages.
Moving Averages in Practice
Moving averages are often used to identify trends, trend reversals, and provide trade signals. Here are a couple’s ways it can be used in your trading strategies.
Support and Resistance
Support and resistances are one of the core elements of technical analysis as they provide essential information about different price levels at which the asset can be traded. Instead of having a horizontal line to define these levels, it is also possible to use moving averages: The 200-day, 100-day, and 50-day moving averages are the most often used for locating substantial, long-term support and resistance levels.
If the price is situated below the moving average: the moving average is to be used as a resistance.
If the price is situated above the moving average: the moving average is to be used as a support.
In this case where Bitcoin was in a bullish trend in 2021, as the price pulled-back, it came close to testing the 50-day SMA support and bounced back on multiple occasions continuing its up-trend until May where the daily trend shifted.
The Moving Average Crossover
It is possible to combine multiple moving averages and use the crossovers as signals. The crossover is a strong sought-after signal that points out a change of their overall market trend. The two main patterns that can be identified on Bitcoin using longer moving averages are:
The Golden Cross: Shorter term moving average crosses over the longer-term moving average providing a strong bullish signal. For example, a golden cross may occur when the 50-day moving average crosses over the 200-day moving average.
The Death Cross: Longer term moving average crosses over the shorter-term moving average providing a strong bearish signal. For example, a death cross may occur when the 200-day moving average crosses over the 50-day moving average.
Short-term Trend reversals
The 20, 10, and 5-period moving averages are often used to spot near-term trend changes. Below are displayed the 20, 10 and 5 period simple moving averages on the 15 min time frame chart. A first signal can be drawn from the SMA(5) crossing the SMA(10) and then a confirmation when the SMA(5) also crosses the SMA(20).
Day trading and scalping
Whilst trading within a day or on very short time frames it is recommended to observe the moving averages over multiple time frames to avoid false signals and increase better positioning and overall win rate. For example, using any combination of 5min, 15min, 1h, 4h moving averages. This can be done by either having multiple charts open with different timeframes or by tweaking the settings of the moving average as seen on trading view previously. Also due to the necessity of rapid positioning from trading short timeframes, the exponential moving averages would be best suited as they tend to form faster than simple moving averages.
The drawbacks of Moving averages
It is important to keep in mind that whilst using moving average indicators that like many trading indicators, passed data is used and results are obtained with a degree of lag therefore, although they can help in making more informed decisions, they do not predict the future.
The Moving average can be a strong technical indicator to start analysing charts and to be implemented in momentum, trend reversal, trend following strategies when combined with other indicators such as RSI, Stochastic Oscillator, Bollinger Bands, Fibonacci, Ichimoku... But it is important to note that its effectiveness will depend on how it is configured and used. Furthermore, it is always essential to have an idea of overall market conditions and drivers.
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Disclaimer: This article is for educational purposes only and is not intended as investment advice.
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