The important to understand is that the each calculation is simple the average price
for a specific time period. By monitoring the behaviour of the average prices, analysts
look to identify any trends in the data. Note in the data above as the closing prices
are rising the average price is behind or “lagging” behind the last calculation.
This is called the lag factor of the moving average. The lag factor is referred
to as the sensitivity of the moving average. The longer the moving average period,
the longer the moving average will lag behind the most recent data. So the longer
the time period of the SMA the less sensitive the moving average will be relative
to a shorter moving average.
Lengths and Timeframes
One subjective decision that traders and analyst cannot avoid is deciding what time
period should be used to calculate the moving average. Most traders will use short
term moving averages identify short-term trends for trading. Typical 5 to 20 periods
are used to calculate short term SMA’s. Analysts tend to be more concerned identifying
secular trends that are usually medium-term trends. Medium term trends can be identified
by SMA with 20-60 periods. The 50-day moving average is the popular for analysing
medium-term trends. Long-term trends can be identified by analyst using moving averages
with 100 or more periods. The 200-day moving average is the most popular for identifying
long term trends.
The most basic use of a moving average is that it allows traders and analyst to
make quick and visual identification of trend direction. The most common way is
compare the last market price to a moving average of choice. If the last price is
above the SMA then the trend is considered upward and if the last price is below
the moving average then the trend is considered downward. By observing the direction
of the moving average we know that a rising moving average means that prices are
increasing. Conversely when we see a falling moving average, we know that prices
Many traders will use different SMA periods to determine if prices are trending
in unison. For example one trader may determine that a 10 period SMA will determine
the short term trend, and the 50 period SMA will determine the intermediate trend
and the 200 period will represent the long term trend. If prices are above all the
time periods a trader will have more confidence trading from the long side and will
be reminded not to trade against the trend. If one or more of the time period are
not in agreement a trader may decide to either wait prices to be above or below
all of the SMA’s to trade or maybe take a very short term low risk trade.
Moving averages often act as support in an uptrend and resistance in a downtrend.
Traders will look to add long positions on market pullbacks and short positions
during bear rallies. It is important to point out one should never expect that moving
averages create exact points of support and resistance. More appropriately moving
averages should be viewed as levels of support and resistance.
Some of the earliest mechanical trading systems have incorporated moving average
crossovers as part of their strategies. These systems use simple price crossovers
to generate buy and sell signals. A buy signal is generated when the market price
closes above a SMA. A sell signal is triggered when market prices close below the
The double crossover uses two moving averages to generate buy and sell signals.
The double crossovers uses two moving averages where one moving average is a short
term moving average and the other is a long term moving average. A bullish signal
known as the golden cross occurs when the shorter moving average crosses above the
longer moving average. Bearish sell signal is called the dead cross and occurs when
the shorter moving average crosses below the longer moving average.
Moving average crossover systems tend to create many false signals when used in
markets that not trending strongly. To reduce the amount of false signals some traders
added an additional moving average. In a triple crossover system, three moving averages
are used and buy and sell signals are generated when the shortest moving average
crosses the two longer moving averages.
Moving Averages are great tools for traders and analysts to have in their arsenal.
One reason for the appeal of moving averages is that they are simple enough and
easy to calculate. Traders and analyst can use SMA’s to quickly identify trend direction.
Another reason for the appeal is that SMA’s can easily used to identify levels of
support, resistance, or create buy and sell signals. Interestingly enough, moving
averages are also versatile enough to be incorporated in elaborate trend following
system too. As with most technical analysis tools, moving averages should not be
used on their own, but in conjunction with other complementary tools.