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Moving averages can be used to help identify trends and potential areas of support and resistance on price charts, helping you identify when to Buy and Sell.
Understanding the concept can also help with understanding other more advanced indicators which are available on your charting package.
A moving average (MA) in its simplest form averages the price over a given period (Simple Moving Average, SMA), smoothing out the price moves of the period and highlighting the underlying trend (up or down).
Signals can be given by moving averages of varying duration (e.g. 20 day, 50 day, 100 day and 200-day are very common) crossing eachother or the price itself crossing through the MAs.
Like all indicators using historical price data, MA is lagging and signals only occur after the trend has changed, so one generally misses the initial upside/downside of a move.
The benefit is false signals usually being avoided, only highlighting genuine price moves. While reward is reduced, crucially so is risk.
The below graph offers a perfect example of a change in trend, with the price falling 30% from April to July before bouncing significantly.
The first buy signal came via the price crossing up through the 20-day MA (red), 50-day (blue), 200-day (Green) and finally the 100-day (black). Combined with the price exceeding its prior highs of 950p, there was the chance that the trend had changed.
After 2 months, however, came the strongest of buy signals, and one which the market tends to watch carefully. A Golden Cross, where where the 50-day MA (blue) crosses up through the rising 200-day (green), before the price got a second wind from 1000p to 1700p. A Dead Golden cross is simply the reverse and can be a sell signal.
One could have gone with the earlier signal of the price crossing up through the moving averages in July and entered the trade at 950p, however, there was still no proof that the trend had changed, and we would have had to wait a few months before the next upleg.
The Golden Cross was later (allowing us to use our capital elsewhere in the interim) and got us in at at only a slightly worse price, and so benefiting from nearly all the reward but with significantly less risk.
See also how the 50-day MA served as support during the rally. It is not uncommon for major MAs to serve as support in an uptrend and resistance in a downtrend.
NOTE: More advanced traders overcome the lagging effect mentioned by using other types of MA which, put more emphasis/weight on more recent data rather than using a straight average: Weighted (WMA), Exponential (EMA).
Moving averages are key within technical analysis, providing additional signals alongside price. Their use is advantageous in increasing the chances of a trade being profitable. Many signals may be screaming Buy (price pattern, volume) but a negative cross by moving averages may suggest a potential for trend change.
Individual technical indicators shouldn’t be relied upon in isolation for trading decisions, however strong the signal. Others should be consulted for extra help, while price (price, price patterns, support and resistance, moving averages, trendlines) and volume should confirm continuation or change of trend. Trend should always be respected as pre-empting a change can prove costly.