How Not To Use Moving Averages Wrongly

Lots of traders use moving averages in their trading but very few use it correctly. In this article, I will share how to use moving average correctly which I teach to my students in the technical analysis course.  Before we get into the details lets understand what is moving average and what are its uses.

Moving average is a trend following lagging indicators. It’s a lagging indicator which means its slow and follows the trend but follows slowly. Being a lagging indicator, its signals are always delayed.

Types of moving average

There are many types of moving averages, but two are the most popular ones

1. Simple moving average 

Simple moving average is the average of past n days price. The basic formula of simple moving average is

SMA= Price sum of n period/n

2. Exponential moving average 

Exponential Moving average applies more weight to recent price. The formula for EMA is

EMA: {Close – EMA(previous day)} x multiplier + EMA(previous day). 

Exponential moving average is quick. It’s more close to recent price. Its gives early signals comparing to simple moving average. Being quick it gives false signals also while SMA is slow, gives delayed signals but more reliable signals than EMA

In the below chart 50 days EMA (blue line ) and 50 days SMA(red line) has been applied. you can see blue line is more close to recent price.

ema vs sma

Uses of moving averages

The primary use of moving average are

1. Trend Identification

The direction of the moving average conveys important information about prices trend. A rising moving average shows that trend is up. A falling moving average indicates that trend is down. A rising long-term moving average reflects a long-term uptrend. A falling long-term moving average reflects a long-term downtrend. The above chart shows the uptrend. The below chart shows the downtrend.

moving average downtrend

When the moving average line is flat it indicates the trend is sideways and moving average signals should not be used in a sideways trend. Like in the below chart.

sideways trend moving average

2. Buy sell signals 

Buy point is signaled when price go above its moving average. A sell point is signaled when the price  goes below its moving average. Buy sell signals of MA in a sideways trend should be ignored.

buy sell signals of moving averages

3. Support and resistance 

Moving averages can also act as support in an uptrend and resistance in a downtrend.

support resistence

Which moving average is best?

This is the most important thing and that’s where everyone makes mistakes. Traditionally 50 100 200 days moving averages act as a psychological support and resistance. These moving averages numbers are used by most of the technicians.  Some traders use Fibonacci based moving average numbers like 13 26 39 54 etc some also use astrology numerology and some also use their lucky numbers. This is where the disaster happens.

How not use moving averages wrongly?

Moving average is a trend following indicator. The primary work of this indicators is to follow the trend and indicate the support and resistance levels. It’s not necessary that numbers like 50 or 100 days SMA will provide support resistance for every stock. The number varies stock to stock.  You have to find which number has worked in the past and that number has the highest possibility of working in the future. Let’s understand with examples.

TCS chart with 20 days EMA

tcs13

You can observe in the above chart the number 20 is not working good for TCS. It’s not  providing a good support.

TCS chart with 45 days EMA

tcs45

The same chart with 45 days EMA giving a perfect support. So for TCS 45 is the perfect number. You have to use the hit and trial method to find out the perfect number. If the moving average line is too close to the price then increase the number, if it is too far then try decreasing the  number.

36 days EMA working perfectly for Hitachi homes.

hitachi

42 days SMA working good for selan oil

selan

So you can understand number can vary stock to stock and fix number won’t work for all. Most of the traders make this mistake of using the same number for every stock.

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8 Comments

  1. Deepa
    September 30, 2015
    • Abhishek
      September 30, 2015
  2. Vijay11
    October 23, 2015
    • Abhishek
      January 4, 2016
  3. Puneet Arora
    January 4, 2016
    • Abhishek
      January 4, 2016
  4. sandeep
    January 23, 2016
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    January 23, 2016

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