Moving averages are a tool used by traders and investors for making trading decisions and analyzing price charts. Like any tool, it is how it is used that determines its usefulness. This article looks at ways moving averages are used and their benefits and drawbacks.
A moving average is plotted on the chart and shows the average price of the asset over a given period. Popular moving averages types include simple (SMA), exponential (EMA), and weighted moving averages (WMA).
Averages over 10 periods, 20/21, 50, 100, and 200 periods tend to be popular choices among traders.
How a Moving Average is Constructed
A simple moving average is calculated by adding up the closing prices over a number of periods, and then dividing the total by the number of periods used.
A period can be any time frame, such as 1-minute candles or daily candles/periods.
Assume a stock had the following closing prices and someone wanted to know the 5-period moving average:
|Sum of Last 5 Closing Prices / 5
|5-Period Moving Average
Note how the simple moving average only uses the last 5 values, since this is a 5-period moving average. If it was a 100-period moving average, we would need 100 closing prices before we could create the first average.
These values are connected on a chart to form a continuous line like the examples below.
Moving averages often use closing prices for whatever time frame is being used (1-minute, hourly, daily, or weekly chart), but the open, high, low, or average of these periods could also be used to generate the data points needed for the moving average.
The following chart shows a 20-period and 100-period moving average applied to it. Since the time frame of the chart is daily, these are 20- and 100-day averages. If it was a 1-minute chart, these would be 20- and 100-minute averages.
How Many Periods to Use in a Moving Average
The chart above compares a shorter average (20) with a longer average (100).
The shorter average tracks the price more closely. It changes direction relatively quickly when the asset price changes direction. This is because the most recent price input has a bigger impact when only a few periods are being averaged. Compare this to the 100-period average, and the last few data points don’t have much impact at all.
Therefore, the longer average reacts slower to price changes. It tends to be “smoother” with less ups and downs. Since it is slower to react to price changes, the price can also move further away from it, while the shorter-term average sticks closer to the price.
How many periods to use is a personal choice based on what you want to accomplish with the moving averages.
Here is a basic summary of what moving averages of various lengths are used for:
- 10- to 20-period MAs will show support for strongly rising prices or resistance for strongly falling prices. See the chart above from June to September, for example. They highlight the short-term trend direction.
- 50-period MA often highlights medium-term trends. If the price is moving higher, small pullbacks will stay above the 50-period moving average.
- 100-period MA captures longer-term trends. On the chart above, MSFT stayed above the 100-day for almost an entire year as it rallied higher. It then undercut the 100-day and the price stayed below it for several months.
- 200-period MA highlights long-term trends. It is a slow-moving average that many traders view as important for signaling long-term direction changes. There are approximately 250 trading days in a year so this average encompasses close to a year’s worth of trading days. The following chart shows how the 200-day does a decent job of highlighting the overall direction of the stock.
Some traders use moving averages in combination with each other.
For example, they may use a 200 and a 50-period, or a 100 and 20, or a 200, 100, and 50.
While these particular number of period are popular, traders and investors can use any number of periods they want: 60, 350, 26, or 113, for example.
What Do Moving Averages Tell Us?
There is nothing inherently predictive about a moving average. It is averaged historical prices. It reacts to prices, it doesn’t forecast them. Since it is using historical data and is not predictive, it is referred to as a “lagging” indicator. It is dragged along by price.
That said, trading strategies can be created using moving averages, and MAs can be valuable analysis tools.
If the price is above the MA, it tells us the current price is above average. This could indicate an uptrend.
If the price is below the MA, it tells us the current price is below average. This could indicate a downtrend.
A trader may choose to only take trades in stocks (or other assets) that are above a certain moving average. In this way, the MA is helping to highlight direction and filter out stocks that are below a specified MA.
A basic scan to find stocks in uptrends might include looking for stocks above their 200-day and 100-day moving averages. If looking for stocks rising sharply, look for stocks above their 50- and 20-day moving average.
Some traders use moving averages for “mean reversion” strategies. This means that they assume the price will return to the moving average after it moves away from it. In this way, a moving average can tell us how far away from average the asset is, which may indicate a move back to the average. We’ll look at an example below.
Moving Average Trading Strategies
Common trading strategies include buying as the price moves above a moving average and selling when it drops below.
Another common approach is to buy when a shorter moving average crosses above a longer-term average, and then sell when the shorter average crosses below the longer one.
These tend to work best in high-momentum stocks. For example, pick stocks that are already in uptrends (above the 100 and 50-period MA average), and then begin applying this method.
Steven Burns has done a lot of testing on moving average strategies, and one of his favorites is the 5 and 20-period crossover. Buy when the 5 crosses above the 20 and sell when it crosses back below.
Mean Reversion Strategy with Moving Averages
Mean reversion strategies attempt to capitalize on the price moving back to the moving average after having moved away from it.
The chart of the S&P 500 ETF (SPY) below has a 20-day moving average (orange) along with additional lines (blue) which are 2% above the MA and 2% below the MA. This is called an envelope.
As the price moves further below the moving average, mean reversion traders step in and buy. They’re assuming the price will return to the moving average, which it often does.
The strategy is enhanced by trading in the trending direction. For example, when the trend is up, buying as the price falls and then turns higher back toward the average. It could also be enhanced by incorporating a smaller chart time frame for the trades. As the price drops for example and is getting extended from the MA on the daily chart, consider dropping to a 15-minute chart and looking for entry points there (turns higher).
Since volatility can change over time, stop losses are important for controlling risk in the event the price continues to move away from the average instead of back toward it.
Moving Average Investing Strategies
One of the simplest moving average strategies that beats buy-and-hold is the 200-day crossover…and trades are only made on the last day of the month. It nearly doubled the S&P 500 returns over the lookback period, according to Steve Burns. This method seems to perform very well over certain periods of history, but not others.
Essentially, buy if the price moves above the 200-day and finishes the month there. Sell when the price falls below the 200-day and remains below on the last of the month. The strategy only buys and then sells, it does not short. Therefore, after selling, the investor is in cash until a buy signal occurs.
The end-of-the-month signal avoids many of the whipsaws which can occur if buying and selling every crossover on the daily chart, for example.
The chart above highlights the big return potential as the strategy captured the entire up move from mid-2020 to early 2022. But then the system also bought before a decline. Such events will happen, and losing trades occur within any system. It’s the results over many trades that matters.
Moving Average Pros and Cons
Moving averages are a tool. It is how we use them that matters. Here are some of the pros and cons of moving averages.
|Moving Average Pros
|Moving Average Cons
|There’s nothing inherently predictive
about MAs. Using them profitability will
typically require additional filters, tools
|Moving average strategies tend to perform
poorly when the price isn’t trending, or choppy, as the price and MAs whipsaw back and forth.
|MAs provide clear-cut buy and sell rules.
|There’s nothing inherently predictive
about MAs. Using them profitability will
typically require additional filters, tools,
|MAs strategies are easy to backtest because of the clear buy and sell rules.
|The ease of backtesting these strategies can
lead to over-optimizing. This is when we custom-fit a MA to maximize profits in the past. But that MA method may not work in the future.
|Customize the MAs to provide signals that work well on the time frame you are trading.
|With so many options, some traders struggle to settle on which MAs to use.
|Moving averages are slower to react to price changes, which means less trading. Moving averages slow us down, which can be beneficial.
|Moving averages are slow to react, which means
we can sometimes take massive losses before the
moving average gives us a signal to get out.
Implementing a stop loss is recommended, even if the strategy provides exit points. This would be need to incorporate into any backtesting results.
Do Moving Averages Really Work For Making Money?
Yes and no.
Putting a moving average on a chart and then taking random trades based on it isn’t going to generate consistent returns.
Developing a winning strategy using moving averages is quite possible. This article has provided some strategy ideas, but these ideas are a starting point. The strategies may not work on all stocks/assets all the time. Therefore, you will need to create additional rules, such as which stocks you will trade with these strategies and when (what conditions must be present?), when you won’t trade, and how will you find the stocks to trade?
All these rules and guidelines are included in our Trading Plan – a written document that outlines how, why, and when we trade.
For example, I only day trade for 0.5 to 2 hours in the morning. I don’t need a strategy that works on daily charts or during the afternoon. I need a strategy that’s specifically designed to work well at that time of day and on the 1-minute chart I’m using. You can find my day trading methods in the EURUSD Day Trading Course.
How I Use Moving Averages
I do not currently use moving averages for day trading. That is not to say they can’t be used. I use price action to determine my trades, it has worked well, so there has been no reason to incorporate moving averages.
I don’t use moving averages in my swing trading for entering or exiting trades. I do use moving averages when I scan for stock trades. For example, when looking for stocks in uptrends, I will look for stocks above their 200-day and often above the 50-day moving average. My swing trading method is covered in the Complete Method Stock Swing Trading Course.
I don’t use moving averages in my investing. My investing strategy is quite simple and involves regularly buying a select group of low-cost ETFs. No analysis is required, so moving averages are not needed.
By Cory Mitchell, CMT
Disclaimer: Nothing in this article is personal investment advice, or advice to buy or sell anything. Trading is risky and can result in substantial losses, even more than deposited if using leverage.