How are moving averages used in trading?
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.
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.