Trading is not all about numbers. You cannot measure everything nor calculate precisely what will be the outcome of your transactions. But you definitely can try, and the closer you get, the better. Moving Averages are quite popular among traders. Let's explore more in this article.
What are Moving Averages?
Moving Averages (MA) are mathematical indicators used to study the changes in prices through time and ultimately predict their future behaviour. They are calculated using sequential data such as opening and closing prices, the volume of trading, etc., divided by determined periods. Those periods can range from some hours up to 10, 20, even 60 days or more.
Basically, a Moving Averages, as its name indicates, gives us an average of the prices through those periods. Thus, they are at the same time a register of what happened and predicting what will happen.
How to use Moving Averages?
Once we have our indicator and know the projected behaviour, we have to keep track of the evolution of the prices. Whenever the behaviour of the financial instrument crosses the Moving Average line, we will have what we call a signal.
A signal means two things: Buy or Sell. If the current price goes above the Moving Average, it's a buy signal. It is time to buy because the price is going to get higher. But if the current price goes under the MA, it is time to sell.
Obviously, you cannot predict exactly the behaviour, so in some cases, the signal will not be 100% accurate, or maybe it will come a little late. Perhaps you will end up buying later and not getting as much profit as possible. Or it might be that you will not sell as soon as you should and lose more than you would have lost if the MAs were more accurate.
That is why there are different types of Moving Averages that can be adjusted to your needs.
Types of Moving Averages
Let's find some of the common types of Moving Averages.
Simple Moving Average
The simplest type of Moving Averages is the Simple Moving Average (SMA). It is very straightforward to calculate. You just need to divide the history of the prices into periods like 12 hours.
Take the closing price and the end of those periods. Make the sum of all the prices and divide by the number of periods. Each point in the line represents the average price of the previous period. Make many points, and you will have more accurate lines
Moving Averages are statistical methods applied to trading. So the SMA is just, literally, the average of prices. It is simple but effective.
Exponential Moving Average
The second most popular is the Exponential Moving Average (EMA). For this to be calculated, we take an initial price value and add a part of the value in the most recent period. This makes the indicator more susceptible to change due to the most recent changes in prices.
The EMA has a better time reaction. It means it adjusts faster to the changes, making it more likely to get the signals faster than what the SMA would give you. But on the other hand, the SMA is more “solid”. This means that the signals you get will be more reliable.
So if the SMA says sell, you sell. If it says buy, you buy. The only advantage is that the EMA may get the signal first, so you could have an earlier entry. This way, your profit potential is maximised.
Linear Weighted Moving Average
The Linear Weighted Moving Average (LWMA) tries to get the EMA's quick reaction along with the SMA's reliability. It accomplishes that by giving more focus to the calculation of the more recent prices.
The “weighted” part is because when it comes to putting the historical values of the prices, they are not taken equally. So, to get the average, the LWMA gives more weight to the more recent prices, making it more susceptible to change rapidly but precise.
Double Exponential Moving Average
A variant of the EMA is the Double Exponential Moving Average (DEMA). The DEMA takes the value of the EMA and repeats the procedure of calculation over the initial EMA value. It means it gets the EMA of the EMA. Then multiplies the EMA by two and subtracts the EMA of the EMA. It is like a “cleaning” of the EMA to eliminate the so-called “noise”. This way, we can get a fast reaction and more reliable indicator
Triple Exponential Moving Average
The TEMA is a similar procedure. The same principle. It takes the triple of the EMA, subtracts the triple of the EMA (EMA2) and then adds the EMA of the EMA2 (EMA3)
If it sounds too complicated, here is the formula: (3∗EMA1) − (3∗EMA2)+EMA3
For the DEMA, the formula is: 2*EMA − EMA of EMA
The only problem with DEMA and TEMA is that they don't react as fast as the EMA in markets with short-term fluctuations, although more reliable than EMA.
So the big lesson always is to study the market you are getting in to find which of the many MAs are preferable to predict its particular behaviour.
In Summary
Always remember that there are no perfect ways to predict any market fluctuation at the end of the day. You can only try to get close to it. That is why experience is the more important factor in trading. Moving Averages are of different types. It is a common indicator among traders because of its popularity. There can be different trading strategies based on moving averages. You can deploy different types of Moving Averages with different periods and on different timeframes.
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