Utilizing Moving Averages in Trading
Cryptocurrency trading is often associated with high volatility or rapid and significant price changes. This means that there is a lot of “noise” in the market, resulting in random price spikes that only give false signals to open trading positions. For this reason, traders use moving averages; a universal indicator which helps identify the moving trend and point out an entry into a trading position.
What is a Moving Average?
Moving Average (MA) is a technical indicator that provides the average price of an asset over a set period of time. MA is one of the most frequently used indicators in trading due to its reliability and simplicity. A moving average is simply the average of a particular data set over a given time period.
This data, in most cases, is represented by closing prices of an asset for a certain period of time. In order to calculate a moving average you need a certain amount of previously acquired information. For instance, a five-day moving average requires five days worth of data, and a 200-day moving average requires 200 days of data.
The main purpose of the MA tool is to “smooth” the information provided by a chart, defining the general trend of an asset. The MA line itself serves as an additional tool for confirming the direction of an asset’s price movement, and can also indicate a trend change.
The reason for using a moving average is that cryptocurrency (and other assets) prices do not move along clearly defined or straight lines even when there is a strong trend. Price forms zigzags and jumps on a chart, so a moving average helps make random price movements in smoother fashion and helps you define the underlying trend. That is, by looking at the slope of a moving average, you can better determine the direction of a trend.
With a customizable indicator, moving averages may have different time frames, which affects how smooth the line itself is. As a rule, the smoother MA is, the slower it reacts to price movement. For example, the 15-day MA will show the variation of the average closing prices throughout the previous 15 candles (15 days).
The calculation is performed as follows: the average closing price of the previous 15 periods is calculated to form the first point of the line on the chart. The next point is also calculated from the 15 preceding periods, and so on. As a result we get the line connecting all of the points mentioned above.
There are several types of MA. The most popular ones are:
- Simple Moving Average (SMA) — This is the most basic moving average, which is a simple calculation of the average price of a set of values over a given period of time; Example: To calculate the SMA for a 20-day period, you need to take the closing prices of the last 20 candles on a 1-day chart and divide the result by 20;
- Exponential Moving Average (EMA) — gives more weight to recent prices to make the indicator more “responsive” than the SMA;
- Weighted Moving Average (WMA) — gives even higher priority to recent periods than the exponential moving average (EMA) because it assigns linearly weighted values to ensure that the most recent prices have a greater impact on the indicator than older prices;
In general, one doesn’t have to calculate the moving averages manually. The main priority is to understand the principle of choosing the best period for each individual trading situation. We will take a closer look at this below.
Simple Moving Average
We have already looked at calculating a simple moving average. All you need to do is take the closing prices of the asset for the last x periods and divide them by x. X determines how fast the indicator changes direction to follow the price.
Here is an example of how simple moving averages smooth out price movements. The chart below plots three different SMAs on a 1-day BTC/USDT chart. As you can see, the longer the period of the SMA, the more it lags behind the price.
Notice how the 62 SMA is further away from the current price than the 30 and 5 SMAs. This is because the 62 SMA adds up the closing prices of the last 62 periods and divides them by 62. The longer the SMA period, the slower the indicator reacts to price movement. The SMAs on this chart show the general mood of the market at a given time. Here we can see that the pair is following an upward trend. Instead of just looking at the current market price, the moving averages give us a broader view and help estimate the general direction of the price movement.
Exponential Moving Average
As mentioned above, the exponential moving average (EMA) gives greater weight to recent period prices, while the SMA is calculated based on a representation of the average of all prices taken over a particular period of time. The formula for the EMA is as follows: EMA = closing price × the multiplier + EMA (previous day) × (1 — multiplier).
There are two moving averages on the 4-hour Bitcoin chart above (SMA 60 and EMA 60). Note that the red line (EMA 60) is closer to the price than the yellow line (SMA 60). At the same time, if the trend changes, EMA changes its direction more quickly than SMA does. That is because the exponential moving average puts more weight into the latest candles, which allows you to “filter out” the fake signals provided by the SMA. For example, in case of a sharp collapse of an asset within a single candle the SMA will continue to move in an upwards direction for some time, while the EMA will give an idea of the price reversal earlier.
SMA vs. EMA
So you may be asking yourself: “Which moving average should I use — simple or exponential?” First, let’s talk about the EMA. If you want a moving average that reacts fairly quickly to price action, the short timeframe EMA is your best choice. It can help you catch new local trends very early, meaning you won’t miss out on a significant amount of potential profit when you open a trade. The downside of using the exponential moving average is that it often gives fake signals during the asset consolidation periods.
Consolidation often refers to a short-term decline in volatility (amplitude of price change) following an explosive push of an asset in either direction. When there is a consolidation, there is no short term trend and it is very risky to open trades based exclusively on the EMA readings.
The SMA, on the other hand, serves as a good confirmation of a trend movement and can save your deposit from numerous false signals. However, this type of indicator reacts to price action slower, so if you rely solely on the SMA you can miss a lot of potential profits by opening a trade late.
Examples of trades
So, let’s first look at defining a trend with the SMA. If the price is above the moving average, the asset is in an uptrend and often the SMA (as well as the EMA) can serve as dynamic support.
Example: A breakthrough and a retest of the SMA 60 on the Bitcoin 4H chart in the green zone and a drop below the SMA in the red zone.
A similar example: a drop below the SMA 28, the asset enters a local downtrend.
To avoid following false indicator signals, traders often draw several moving averages on the chart at once. If, in this case, the SMA based on a shorter time period is above the longer timeframe SMA, the asset is in an uptrend. Notice how the lines are almost touching, confirming the up-trend (on the chart SMA 60 is marked yellow and SMA 30 is red).
Another way to utilize two SMAs is to enter a position as the lines cross. On the chart below, the SMA based on a shorter time period crosses the longer timeframe SMA, indicating a change in trend (from an uptrend to a downtrend). This gives the trader confirmation to open a short position. Moving averages are lagging indicators, so a position should be opened some time after the signal. Remember, the lower the period, the shorter this time interval is.
During the current Bitcoin price rally, the SMA 200 on the 4H chart served as an excellent dynamic support. The chart has touched and even briefly crossed the line several times, but over the past few months, all of these interactions have only provided an excellent signal for opening a long position.
Moving averages are just one of the tools, completing the arsenal of a trader. That is, this indicator is best used in combination with horizontal support/resistance levels and trendlines.
Let’s recap the main points you need to know about moving averages. Moving averages based on a longer time frame are smoother than the ones with a shorter time period as their base. Using an exponential moving average can help you identify trends faster, but it often produces a lot of false signals. Simple moving averages are slower to react to price action, but will keep you away from rushing into opening a position.
However, they can hold you back from making a trade, and lead to missing out on potential profits. You can use moving averages to determine the trend, decide on the entry position and see if the trend is coming to an end. Moving averages can also be used as dynamic support and resistance levels. One of the best ways to use moving averages is to take advantage of multiple MAs with different time periods so you can see both long-term and short-term movements.