A moving average is an average of a predetermined number of prices such as the closing prices calculated over a number of periods like 50 candles. The higher the number of candles in the average, the smoother the line is.
Moving averages are of two types. 1) Simple Moving Averages (SMAs). 2) Exponential Moving Averages (EMAs). SMA is only a simple average. It is obtained by adding all the candles that you would like to measure. EMA is obtained by exponentially smoothing the SMA. The EMA responds more quickly to price changes as compared to SMA. EMA pays more attention to newer candles.
A moving average makes it easier to visualize price action without statistical noise. Instead of watching the up and down behavior of each candle, you are watching the relatively smooth moving average line.
Moving averages are lagging not leading indicators. Its signal occurs after the new price movement not before it. Moving averages do not think ahead. They can tell you what has happened, not what will happen.
Nonetheless, MAs have a critical role to play. MAs should be an essential tool in planning your trades in advance. Past price action does not always predict the future price action. But price action sure likes to repeat itself. Several different MAs are used at once on the same chart. These different MAs offer different pieces of the puzzle when we plan our trades.
MAs keep us in our trades when the market is steadily rolling forward. Suppose something changes like the moving average crossover. Its time to get out or trade the new direction. MAs are frequently used as price filters.
A short term moving average has to cross a long term moving average to filter choppier price action into a reliable indication for true price action. The most obvious use of MAs is to watch for crossovers to confirm new trends.
Short term MAs are more sensitive to price action because they are measuring fewer candles. Longer term MAs are less sensitive to price action, tend to be more flat and are less likely to whipsaw up and down.
When moving averages do crossover you should take notice at once. If the fast EMA crosses below the slow EMA, it is predicting new downward price action. If the fast EMA crosses above the slow EMA, it is predicting a new upward price action.
MA crossovers often occur too late and will put you in the market with an unfavorable risk to reward ratio. Beware such crossovers should not prompt you to jump into a trade at once.
A crossover should be part of the trade plan that you have developed in advance. Not every crossover is the same. Moving average crossovers are great as they are easy to see. It will immediately attract your attention but simply do not replace the work of planning your trades.
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