Moving averages are the most popular lagging indicator used by traders. The reason why MA’s are important to most traders is that they are used by every trader, unlike other indicators that are only used by retail traders. For example, the market makers in the Forex Market are large banks. Large banks rely on MA’s as a tool to make their trades. Commonly they use the 200-day moving average in this marketplace.
Institutional traders such as Goldman Sachs or other large Fund Managers use MA’s in the stock and commodities market to make buying and selling decisions. Due to the market makers using MA’s , they are something that every retail trader should use to help them understand price action better.
What Are Moving Averages?
Moving averages are called a lagging indicator because they are a sum of previous periods that are averaged to show you a trend. The timeframe you use to calculate the MA will change the trend line dramatically. If you are looking at a 10MA on a minute chart then this will be a 10-minute average. Likewise, a 10MA on a daily chart would be an average of the last 10 days. There are two different types of MA’s that are used by traders.
Simple MA’s are easy to calculate and are generally used for longer time frames. A simple moving average is calculated like I described above as a simple mean plotted to show a trend. The trader will look at this line to try and predict where the price will go in the future.
The exponential moving average has a smoothing factor added into the calculation which you would need to understand statistics to calculate by without software. This smoothing factor helps a trader use moving average on shorter timeframes. It is common for a trader to use a 10 and a 20 period MA that is exponential with a 100 to 200 simple moving average.
The bottom line on moving averages is that a simple or an exponential average will have different uses. The best thing to do is try different techniques and find a corilation between ma’s and price action.
How Can Moving Averages Help You?
Find the direction of the overall trend
Sometimes it is very easy to see the long term or even short term trend in the market. As a trader, you always want to find confirmation in all of your trades. Trend lines can help you spot the overall trend of a bull or bear market.
Spot a trend Reversal
Moving averages also help you see a change in the direction of the market. Price or other moving averages crossing can mean that there is a change in the overall trend. The reason this is significant is because the market makers buy and sell off the moving averages. This can give you insight on where the market is heading in the future.
Find Entry and Exit Point
Moving Averages can also help you find buying and selling opportunities. One trading strategy that uses this is called momentum trading. A momentum trader will have the motto buy high and sell higher. Above the Green Line is a great example of someone who uses this strategy successfully. This strategy only buys stocks and ETF’s that are above their 100-day MA.