One of the most well-known trader wisdom is: “The trend is your friend.” Anyone who has ever traded as a trend follower can agree to this. There are several ways to define a trend – the classic Dow theory of rising or falling highs and lows or the mathematically more sophisticated linear regression. And, of course, there is also the possibility for traders to draw trend lines manually in their chart program.
Many profitable trading strategies involve entering a market with an above-average chance of a new trend forming. Then, when a trend does exist, the key to success is following the trend throughout its lifetime. Such trends are best represented as moving averages.
What is a moving average?
You can calculate moving averages over any factor that changes over a period of time. In technical analysis, its calculation is based on the price changes of the considered trading instrument over a certain period of time.
A moving average is a value calculated continuously by averaging a price over a specified period of time. The sliding of the indicator, i.e. the average, is because its value adapts to the continuous period with each price change.
For example, we can use a 30-day moving average. The value is the arithmetic mean of the price over the last 30 days. In other words, we sum each of those 30 closing prices and then divide the result by 30. This value is calculated each day, discarding the oldest value in the data set in favor of the most recent elapsed day.
The effect of moving averages is to smooth out price fluctuations. This helps us look past temporary or insignificant price fluctuations and instead see the market’s longer-term trend or individual stock.
Advantages of moving averages
Moving averages have two advantages as a signal generator: they move with the price… and they are used by many investors as a basis for decisions on entering, exiting, and increasing a position. This immediately brings up a premise you should remember when creating a trading system.
Economists and analysts have long used moving averages in their studies. In the pre-computer era, calculations were done by hand or with the help of a calculator. Needless to say, this was very time-consuming. For this reason, calculations have tended to be performed based on end-of-day data.
Technological advances have put us in a much more comfortable position today. At the push of a button, we have the values for pretty much any time frame available. Later we will look at how the MA indicator works in MetaTrader and which buttons can be used to control and adjust it in the trading software.
Time values for moving averages
The most common time grids for moving averages are 20 days, 50 days, 100 days, and 200 days. 50- and 100-day averages are used more in the US, while 20-day and 200-day averages dominate in Europe. You should consider this to integrate European stocks into your trading.
If you like things super simple and straightforward, you can limit yourself to a single moving average on your chart and still have the same information as a trader using multiple indicators for signaling. This simple indicator – and nothing else is a moving average – provides a variety of information that is important for successful trading.
Price charts can sometimes be confusing. Big corrections can cause traders to lose track and ignore trends. Maybe they get distracted by the many ups and downs in the chart. Long-term moving averages help you stay focused. Traders can quickly see if a trend exists by applying a long-term moving average to their chart.
After trend lines, moving averages are the most popular technical analyst tools. This is because the concept of moving averages is easy to understand and demonstrate due to its usefulness in trending markets.