How are moving averages used in trading?

By Casey Murphy AAA
A:

Moving averages are very popular tools used by technical traders to measure momentum. The main purpose of these averages is to smooth price data so traders can be in a better position to gauge the likelihood that a current trend will continue. Moving averages are commonly used to predict areas of support and resistance and are also used in conjunction with other indicators to help give more accurate entry/exit signals. There are different types of averages that vary in popularity but, regardless of how they are calculated, they are all interpreted in the same manner.

A crossover is a popular trading signal that occurs when the price of an asset crosses through a moving average, or two moving averages cross over each other. This type of signal is regarded as an early indication of the direction of future momentum. For example, traders wishing to enter into a long position will buy an asset when the price crosses above a moving average and sell the asset when it crosses below. As you can see from the chart below, upward momentum increases when a short-term average crosses above a long-term average.

macross_1r.gif

Moving averages are often used to predict areas of support and resistance. As you can see from the diagram above, the price of an asset often finds support at major averages such as the 50/200 daily moving averages. Traders use these averages to help them to choose strategic areas to set price targets or stop-loss orders. Many traders exit their positions once the price of the assets falls bellow major moving averages because it suggests that downward momentum is likely to increase.

The smoothing characteristics of moving averages are often applied to other technical indicators to help reduce the chance of getting a false transaction signal. A short-term average is often applied to indicators such as the stochastic oscillator, moving average convergence divergence (MACD), price rate of change (ROC) and on-balance volume (OBV) to generate transaction signals. This average is known as a trigger line and transactions are made when the indicator crosses through this average. In general, long positions are taken when the indicator crosses up through the trigger line and short positions are taken when it crosses down.

For further reading, see the Moving Averages Tutorial.

RELATED FAQS

  1. How do technical analysts interpret the Average Directional Index (ADI)?

    Learn what the average directional index is and why technical analysts look towards ADX indicators to measure the strength ...
  2. What does a double bottom tell a trader about the overall trend?

    Learn how a double bottom pattern forms on a price chart and why many traders consider double bottoms to be a sign of reversal ...
  3. What are the main differences between a double top and a double bottom?

    Identify double tops and double bottoms, and learn what each could mean for the security's current price trend. Discover ...
  4. What are common trading strategies used when identifying a double bottom

    Use simple, low-risk trading strategies to take advantage of a double bottom formation. Traders typically take one of these ...
RELATED TERMS
  1. Mass Index

    A form of technical analysis that looks at the range between ...
  2. Money Flow Index - MFI

    A momentum indicator that uses a stock’s price and volume to ...
  3. On-Balance Volume (OBV)

    A momentum indicator that uses volume flow to predict changes ...
  4. Negative Volume Index - NVI

    A technical indicator that relies on changes in a security’s ...
  5. Accumulation/Distribution

    An indicator that tracks the relationship between volume and ...
  6. Force Index

    The Force Index is an oscillator that fluctuates above and below ...

You May Also Like

Related Articles
  1. Options & Futures

    The Potential Of Low-Priced Options

  2. Trading Strategies

    An Introduction To Price Action Trading ...

  3. Trading Strategies

    Trading Volatile Stocks with Technical ...

  4. Technical Indicators

    The Top Technical Indicators For Commodities ...

  5. Trading Strategies

    Day Trading Strategy Steps

Trading Center