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What is a Moving Average Indicator?
The Moving Average Indicator is an indicator that is calculated as the arithmetic mean of the previous n number of days’ prices, for example, the mean of the last 10 days’ closing prices. It is a trend-following indicator that acts only after the price has taken an action.
Introduction
Trading indicators are the quintessential part of a technical analyst who needs to know the trends for crypto and stock performances. If you are not a beginner in crypto trading, you might be aware that a this Indicator is one of the most commonly used indicators that trade analysts use. Apart from being very simple to understand and use, the signals indicated by it are quite accurate (though this is not always the case).
Let us assume that we want to construct it based on the last 20 days’ closing prices of crypto. So, we calculate the it by calculating the mean of these prices.
Arithematic Mean = (P1 + P2 +P3 +….. +P20)/n
Where P1 is the closing price of the stock on the first day, P2 is the closing price on the second day, and so on… And n is the number of days we want to keep in consideration for our calculation.
The above formula calculates a 20-day signal of the closing prices. Along the same lines, you can calculate this signal for any number of days: 10, 15, 50, 200… And so on.
That was for the “average” part. But why is it called “moving”? Suppose today, you calculated the 20-day average for the last 20 days. But that is the value of the point on the chart for today. Tomorrow, you will again calculate the average price for the last 20 days, which would mean the first day in the calculation of the previous calculation would be removed and a new day would be added.
This means your signal is moving over prices. As only the latest 20 days have to be kept in the account, the “last 20 days” keep on moving forward. Every day, you will add a new closing price to the calculation to calculate the new point for that day. Simple and easy, isn’t it? Do not worry about these calculations though; simply adding them to your stock chart is all you have to do.
Main Features
It is a Trend-Following Indicator
M.A. follows the trend. For this reason, it is also called a lagging (not a leading) indicator as it is based on past prices. It indicates the trend of the market (bullish, bearish, or sideways). It is called a lagging indicator because it shows movement only after the price has moved.
For example, if the price of crypto is rising and after a while, it starts dropping, this indicator will show this fall only after the price has already dropped and not before that. It is for this reason, M.A. is called a trend-following indicator as it is based on the prices of past days. You do not use it for predicting a trend. Instead, after the trend has happened, it is used for confirming the trend. See the chart below: while the price has started falling but the Indicator is still doing sideways.
It is Used for Smoothing the Prices
As calculating M.A. involves creating an updated average price each day, the price values get smoothed out. As the prices are smoothed, it becomes easier for the user to view the trend. To understand this, you can compare a short MA (say 10-day) with a longer one (say 50 days or 200 days). You will see that the short-term signals are closer to the price line while the longer ones, on account of being more smoothed out, are farther from the price line. This indicates that the short-term MAs react more quickly to price actions while the longer ones are less sensitive.
Longer ones lag more behind prices than shorterones. This is because more price data is involved in longer MA than a short MA.
Shorter vs Longer: Which One is More Accurate?
We read in this article that the short one is more sensitive to price action and is closer to the price chart. If the price takes too many turns frequently, this shorter would also move more and would generate several false signals. Though too many crossings of the shorter indicate several opportunities for traders, unless they are expert enough, they would tend to lose money due to several false signals generated. In such cases, a longer one is more useful as it is less sensitive to price action.
On the other hand, the shorter being the sensitive ones give signals much earlier than the long ones. As we know, an M.A. is a lagging indicator, a shorter one would lag less as compared to the longer one.
A big drawback of the longer ones is that when a trend reverses, they lag too much and continue to show the same trend that they were showing till now.
So, when it comes to accuracy, long signals are more reliable. When it comes to predicting the signals early, short ones are better to use. A trader has to find a route in between. The best strategy would be to select a long when the price is already in trend (upwards or downwards) and shorter signals are more useful when it comes to trend-reversal as they react to them quickly.
Types of Moving Averages
Simple Moving Average (SMA)
What you have studied so far was in the context of SMA, i.e. the those that are calculated by finding the arithmetic mean of the fixed number of prices. But SMAs can have some pitfalls. For example, as per some trade analysts, SMA gives equal weightage to all the prices, no matter what the price is. This can be accounted for by other types of MAs like Weighted and Linear Weighted.
Weighted Moving Average Indicator (WMA) or Linearly Weighted Moving Average (LWMA)
Unlike SMA which gives equal weight to all the prices in consideration, WMA gives more weightage to the recent prices and less to the past prices. This is achieved by multiplying every price point with an equal weightage factor. For example, in the case of a 5-day average, the closing price of the 5th day is multiplied by 5, the price of the 4th day is multiplied by 4, and so on. This way, more weight is granted to the more recent prices than the distant ones. These are all added and then divided by the sum of the number of days chosen. For example, in this case, this would mean 15 (=5+4+3+2+1).
Let us consider the prices over 5 days are:
First-Day Price: $ 20.2
Second-Day Price: $20
Third-Day Price: $22.5
Fourth Day Price: $19.4
Fifth Day Price: $22.6
Therefore, WMA = [(20.2*5) + (20*4)+ (22.5*3)+ (19.4*2) + (22.6*1)] / (5+4+3+2+1)
= 311.4 / 15
= 20.76
Exponential Moving Average Indicator
It is also a type of WMA with the difference that the difference between weightage assigned to one price and the price previous to it is not consistently the same. For example, the last day’s price weightage could be given 10% while the previous day could be given a 90% weightage.
A trader depending on his experience and discretion can use the best MA Indicator, the one s/he considers would give the most accurate signals.
Hull MA Indicator
Among all the types of these types of indicators, a relatively new one, called Hull Moving Average Indicator, is the fastest one. It removes the lag of the MA to a great extent. When an HMA Indicator is rising, the price of the crypto asset is expected to rise. Conversely, if it falls, it is an indication that the price will also fall.
Most Common Signals Used by Trading Analysts
These are a few signals that trading technicians use frequently:
- Rise and Fall: A raising M.A. indicates that the trend is up and the prices are raising while a falling M.A. indicates a downtrend and indicates that the prices are falling. This must be clear from the charts that we have seen so far.
- Moving Average Crossover: This is called a crossover signal and is very popular among traders and investors. According to this, when a short-term crosses above the long-term, it is a bullish signal (prices are expected to go up) and when a short-term crosses below the long-term , it indicates a bearish signal (prices are expected to go down). As two signals are used, this is also known as the double cross-over method.
- Buy and Sell Signal: Suppose you have plotted it on your closing price chart. Traders consider it a buy signal when the price goes above the indicator and a sell signal when the price goes below the indicator.
- Golden Cross and Death Cross Signals: Traders consider it a Golden Cross when a 50 MA (shorter one) crosses above a 200 MA (longer one). This indicates a bullish trend. The reverse of this is the Death Cross when the opposite happens: a 50 MA crosses below a 200 MA. This indicates a bearish trend is about to start. Instead of the 50 and 200 MA values, a trader can select any short and long values.
- WMA Signal: When the price moves below the WMA, it indicates a downtrend and vice versa is also true,
- Triple Crossover MA Arithmetic Mean = (P1 + P2 +P3 +….. +P20) crossover Signal using 4-9-18 Averages: Some trade analysts use 3 MA Crossover Indicator technique. Generally, 4-9-18 day indicators are used for this purpose. The 4-day one, as we know by now, being the shortest, follows the price tightly, followed by the 9-day and then by the 18-day. For an uptrend, the 4-day line goes above the 9-day and then by the 18-day line. The reverse of this for the downtrend is also true.
The buying signal in the 4-9-18 triple crossover uptrend happens when the 4-day one crosses above the 9-day and the 18-day. When the 9-day also crosses above the 18-day, this buying signal is confirmed. In the downtrend, this scenario is exactly reversed: When the 4-day one crosses below the 9-day, it indicates a sell signal which is confirmed when the 9-day crosses below the 18-day.
7. Moving Average Envelopes Signal: An envelope around it indicates the overbought (extended uptrend) and oversell (extended downtrend). This envelope is expressed around an MA as a percentage. For example, a 10% envelope around a 20-day MA is shown in the chart below. When the price touches the upper band of the envelope, it indicates that the prices have been overbought and we are in an extended uptrend, so it is indicative of the upcoming downtrend. When prices touch the lower band of the envelope, it means we are in an extended downtrend and the trend is about to change.
Criteria for Creation of This Indicator
As we saw above, we talked about the 20-day signal based on closing prices for those 20 days. But this is not the only criterion. Trading analysts can choose from a number of these: select a short-term signal or a long-term one, how many days to take into consideration to calculate, which one to use in which type of market, etc. There are a whole lot of these selections that a trader or investor can make depending on what suits his/her strategy the best.
When to Not Use Them?
These works well when there are trends (uptrend or downtrend). But at times, when the market is going sideways for a longer period, it may not be a great choice to rely on the this indicator as the price choppiness might confuse you and give you a lot of false signals. Even during the trends, you are advised to not rely on the them solely and use other indicators also to confirm the signals.
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Anuradha
A blockchain writer and a cryptocurrency enthusiast. First-hand experience of working in web3 domain in which I create blockchain content for both developers and end-users. A blogger by choice and passion. My interest in blockchain is only growing up with the passage of time.