Moving Averages (MAs)

As mentioned in the previous section, moving averages are among the most commonly used tools for trend analysis in financial markets. Many technical indicators are built upon them.

Moving averages (MAs) help smooth price movements over a certain period, providing a clearer view of the overall market direction without the noise of short-term fluctuations. They are calculated by averaging the closing prices of the market over a specified number of trading periods.

How moving averages work

A 20-day MA calculates the average value of the market over the past 20 days, giving a broader view of the trend.

A 5-day MA considers the average price over the past 5 days, allowing it to respond more quickly to price movements.

MAs can be calculated for any future period depending on the preferred trading strategy.

Types of moving averages

There are several types of moving averages, each calculating average values differently. The most commonly used are the Simple Moving Average (SMA) and Exponential Moving Average (EMA).

The Simple Moving Average (SMA) is calculated by averaging the closing price of the market over a set period, with the result being based on the number of periods.

For example, if you wanted to calculate the 5-period SMA for the EUR/USD currency pair, you simply sum its closing prices over the past five periods (whether they are minutes, hours, or weeks) and divide the sum by five.

Note: Longer time frame MAs provide a more stable view of the market and react more slowly, while shorter MAs are more sensitive to changes but may generate more false signals.

The calculation of the Exponential Moving Average (EMA) is somewhat more complex because it places greater emphasis on recent price movements. This makes the EMA more responsive to market changes compared to other moving averages.

When you use a moving average on a price chart, it automatically updates with each new trading session. This results in a trendline that follows the price development of the asset being tracked.

It’s important to note that the more periods you include in the average calculation, the further the MA will be from the current price, as it responds more slowly to new price movements.

The most popular moving averages cover 5, 10, 20, 50, 100, and 200 days.

Trading with MAs

In general, the market is considered bullish when the price is trading above the moving average, and bearish when it is trading below it. In addition, there are several other common signals that traders watch for when deciding to enter a position:

• Buy signal – when the moving average is rising and moving upward.

• Buy signal – when the price closes above the moving average.

• Sell signal – when the moving average is falling and moving downward.

• Sell signal – when the price closes below the moving average.

Traders often combine multiple MAs with different timeframes to better identify the trend direction and potential entry and exit points.

Moving average crossovers

One of the popular strategies in trading with moving averages is watching for crossovers, which occur when two different MAs cross each other. This method uses two moving averages with different timeframes:

• Slower MA – has a longer timeframe, such as 50 days or more, reflecting the overall trend.

• Faster MA – uses a shorter timeframe, such as 15 days or fewer, reacting more sensitively to current price movements.

A crossover occurs when the faster MA crosses the slower MA:

• Bullish crossover (Golden Cross) – when the short-term MA crosses the long-term MA from below to above, signaling a potential upward trend.

• Bearish crossover (Death Cross) – when the short-term MA crosses the long-term MA from above to below, indicating a possible downward trend.

The levels at which these crossovers occur may also serve as new support or resistance levels, which traders monitor when planning their entry and exit points for trades.

One of the disadvantages of using moving averages (MAs) is that they are lagging indicators. Since they are based on historical price data, they respond with a delay to current market movements.

For this reason, MAs can provide false signals, especially in situations where the expected move has already ended by the time the indicator signals an entry into a trade. This can lead to delayed decisions and potentially reduce the effectiveness of the strategy.

To minimize the risk of false signals, traders often combine MAs with other indicators, such as volume indicators or oscillators, which can provide additional confirmation of the trend.

MACD – Moving average convergence divergence

In addition to using moving averages on their own, they form the basis for various technical indicators. MACD (Moving Average Convergence Divergence) is one of the most well-known tools that uses moving averages to identify the strength of a trend and potential reversals.

When you activate the MACD indicator on a chart, it will appear in a separate panel, typically at the bottom of the screen. The indicator consists of three main components:

• MACD Line – This is calculated by subtracting the 26-period EMA from the 12-period EMA.

• Signal Line – This is a 9-day EMA of the MACD line, used to smooth out signals.

• Histogram – This visually represents the difference between the MACD line and the signal line.

Interpreting the MACD:

• If the 12-period EMA is higher than the 26-period EMA, the MACD line is positive, indicating a bullish trend.

• If the 26-period EMA is above the 12-period EMA, the MACD line is negative, signaling a possible decline.

Did You Know?

The 12 and 26 days are the default settings for the MACD, but they can be customized according to your trading strategy and time frame.

Trading with MACD

When trading with MACD, traders focus on three main signals:

1. MACD and Signal Line Crossovers

2. Zero Line Crossovers

3. Divergences

Crossovers, zero line crossings, and divergences in MACD

Crossovery is one of the most commonly used signals in the MACD indicator. Just like with standard moving averages (MA), when the MACD line crosses the signal line, it can indicate a trend reversal.

• If the MACD line crosses the signal line upwards, it is considered a bullish signal, indicating a possible uptrend.

• If the MACD line crosses the signal line downwards, it is a bearish signal, indicating a possible downtrend.

Another important point to monitor is zero line crossovers. This refers to when the MACD line crosses the zero line:

• If the MACD crosses below the zero line, it may indicate a bearish trend.

• If the MACD crosses above the zero line, it could signal the beginning of a bullish market.

Divergences occur when the market moves in one direction but the MACD indicator does not follow it.

• If the market makes a new high but the MACD does not reach higher values, it may form a bearish divergence, suggesting weakening momentum and a potential reversal.

• Conversely, if the market makes new lows but the MACD does not create lower values, this can signal a bullish divergence, forecasting a potential upward market reversal.

This disconnect between the price and the indicator shows that the market and MACD are not in sync, which often leads to a trend reversal. Traders use these signals to better time their market entries and exits.

Important Note:

It's crucial to keep in mind that moving averages (MAs) are lagging indicators, meaning they react to price movements with a delay. Since MACD is derived from moving averages, it can lag even further, which may cause some signals to come too late.

For this reason, it's important to watch out for false signals and combine MACD with other analytical tools to confirm trends. Equally important is risk management—using stop-loss orders and setting appropriate risk management features can help minimize losses if the indicator turns out to be unreliable.

Profit target and risk-to-reward ratio

When entering a trade, having a profit target is equally important. Traders use different approaches for setting profit targets:

• Some traders choose a fixed profit target, such as twice the risk (risk-to-reward ratio of 1:2).

• Others wait for the EMA crossover to occur as an exit signal, but this might result in longer trade durations and uncertainty as the signal appears.

In this scenario, a suitable profit target could be set to 15–20 pips with a stop-loss just below the EMA crossover, providing a risk-to-reward ratio of approximately 1:3.

Other approaches to day trading

Although this example uses moving averages, traders have other essential technical indicators and strategies at their disposal for day trading. Some of the most common include:

• MACD – tracks momentum and potential trend reversals.

• RSI (Relative Strength Index) – measures overbought and oversold levels in the market.

• Fibonacci retracements – help identify key support and resistance levels.

Each of these tools offers a unique perspective on price movement and can assist traders in identifying optimal entry and exit points in the market.