Part 2
Technical Analysis, Part II: Moving Averages
This is Part Two of our Fundstrat Academy piece on Technical Analysis.
Read Part One here.
Moving Averages
What are moving averages?
Moving averages (MAs) are statistical tools used in technical analysis to smooth out price data and identify the direction of a trend. By averaging the prices over a specified period, moving averages help filter out short-term fluctuations and highlight the underlying trend. There are several types of moving averages, with the Simple Moving Average (SMA) and Exponential Moving Average (EMA) being the most common.
Types of moving averages
- Simple moving average (SMA): The SMA is calculated by summing the closing prices of a security over a specific period and dividing the resulting number by the number of periods. For example, a 10-day SMA adds the closing prices of the last 10 days and divides by 10.
- Exponential moving average (EMA): The EMA gives more weight to recent prices, making it more responsive to new information. The calculation involves a smoothing factor that increases the importance of the most recent data points.
Using moving averages
Moving averages are used in various ways:
- Trend identification: The direction of the moving average indicates the trend. An upward-sloping MA suggests an uptrend, while a downward-sloping MA indicates a downtrend.
- Support and resistance: Moving averages can function as dynamic support and resistance levels. Prices often bounce off these averages, providing trading opportunities.
- Crossovers: When a shorter-term moving average crosses above a longer-term moving average, it generates a bullish signal (golden cross). Conversely, a bearish signal (death cross) occurs when a shorter-term MA crosses below a longer-term MA.
Popular moving-average strategies
- Moving average crossover strategy: This strategy involves using two moving averages of different lengths (e.g., a 50-day SMA and a 200-day SMA). Buy signals occur when the shorter MA crosses above the longer MA, and sell signals occur when the shorter MA crosses below the longer MA.
- Price crossover strategy: This strategy involves trading based on the price crossing above or below a moving average. For instance, buying when the price crosses above the 50-day SMA and selling when it crosses below.
Limitations of moving averages
Moving averages are lagging indicators, meaning they follow the market and may not provide timely signals in rapidly changing conditions. Additionally, they can generate false signals during sideways or choppy markets.
A faster moving-average calculation that offsets values in order to reduce the traditional lag found in moving averages is the Double Exponential Moving Average (DEMA) – a technical indicator that reduces the lag of traditional Exponential Moving Averages (EMAs), making them more responsive, generating a smoothed line that is much closer to the price bars than either EMA1 or EMA2 (see chart below).
The price bars above are plotted in what is known as a candlestick chart, which reflects the open, high, low, and close values. Click here for more on candlestick charting.
Bollinger Bands
Employed as a complement to moving averages, Bollinger bands measure volatility via a chart overlay of the moving average (placed above and below) showing the upper and lower limits of ‘normal’ price movements based on the Standard Deviation of prices.
Look for our exploration of Momentum and Volume in Part 3 of the FSI Academy series on Technical Analysis.
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