ZYTrade: We often use moving averages when illustrating our technical outlook. Moving averages are one of the oldest and most fundamental technical tools to gauge trends. If you’re not sure how they work, or if you want to learn more about their uses and limitations, check out this article–a basic primer on moving averages.
What Is a Moving Average Chart?
A moving average (MA) chart is a tool used by technical analysts to track the price movements of a security. It plots average prices over a defined period of time, with the moving average typically overlaid onto a candlestick or bar chart. The bars or candlesticks show the price data for each time period.
While a lot of information is lost, once the moving average is applied to the chart the price data could be hidden. This way the viewer only sees the smooth moving average and its trajectory, not the period-by-period price data which can appear erratic.
- A moving average chart depicts the average price of a security over a specified number periods, shown as a single line overlaid onto a standard price chart.
- Moving averages smooth out the period-to-period price fluctuations, helping to highlight the overall trend direction.
- Longer-term MAs highlight longer-term trend direction, while shorter-term MAs highlight shorter-term trends.
- Moving averages are a lagging indicator, based on historical data, and are not necessarily predictive.
What Does a Moving Average Chart Tell You?
MAs have the advantage of smoothing out price data by creating a constantly updated (moving) average price. In most cases, moving averages are overlaid on a price chart. This way the trader can see the period-to-period price movements as well as the smoother line of the MA. This average can be adjusted to a trader’s preferred time horizon:
- The longer the MA selected (more periods calculated) the slower that MA will react to price changes. A long-term MA is useful for indicating the longer-term trend.
- A shorter MA (few periods calculated) will react quicker to price changes and is useful for indicating the short-term trend.
The simplest benefit of smoothed data is its ability to filter out “noise.” Noise is the period-to-period price fluctuations that can distract the trader from the bigger picture or trend.
Another popular use of the moving average is the concept of support and resistance. In some cases, but not all, a security may rise after dropping to the MA. In this case, the MA is acting as support. This tends to occur when the MA is rising overall. If the price rallies up to the MA, and then declines after reaching it, the MA has acted as resistance. This tends to occur when the MA is moving lower and the price is in a downtrend.
Some traders prefer to solely focus on the smoothed data, and ignore short-term price fluctuations completely. After applying the MA, the price data is hidden, so all they see if the MA and its trajectory. The downside of this is that MAs are slow to react to price changes, which means the price may have a drastic move yet the trader may not notice and be able to react to it till too late.
Example of How to Use a Moving Average Chart
The following chart depicting the historical stock price Facebook Inc. (FB) has two MAs applied to it, a 200-day (orange) and a 21-day (blue).
The 200-day MA shows the overall trend. When the price is above this MA, the overall trend tends to be up. When the price is below it, the price tends to be in a downtrend, since the current price is lower than the 200-day average price. The 21-period MA shows the short-term trends, capturing the smaller price waves.
A trader may only wish to buy when the price is above or close to the 200-day MA. In this way, the longer-term moving average acts as a filter, helping the trader to only trade in the overall trend direction. The 21-day may help with determining short-term trading opportunities, such as getting in or out of trades when the price crosses above or below the 21-day.
The Difference Between a Moving Average and Volume-Weighted Average Price (VWAP)
A moving average (based on price) only looks at price. VWAP takes into account price and volume, showing where most of the trading has taken place. VWAP is often used by day traders or institutional traders for assessing whether they overpaid or underpaid for a security.
Limitations of Using a Moving Average Chart
The moving average calculation looks only at averaging historical prices. This average may not provide predictive insight in terms of where the price is going next. The moving average is a lagging indicator, meaning it follows price, moving only once the price itself has already moved.
While the MA may sometimes act as support or resistance, the results could be considered random, since the price often overshoots or fails to reach the MA before bouncing (up or down). Also, the price may not respect a MA at all.
Originally posted on Investopedia
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