Basics of Moving Average Indicator & trading strategy

Moving Average is an indicator that shows the average price of the instrument like a stock or indices in shape of a line on the chart. It is a trend following indicator or known as a lagging indicator, because it doesn’t give any alert for prediction of future price movement, rather it shows the present trend of the price movement on the basis of past price data. Basically Moving Averages takes the closing prices to calculate the average price but you can select any price like the opening, high or low price also.

Let’s know how do you calculate a moving average,

For example – A 9 days Moving Average will show the average of closing prices of the last 9 days, that will be calculated as –

9 Days Moving Average will be = Total Price of previous 9 days divided by 9

= (104+103+102+101+100+99+98+97+96) / 9

= 900 / 9 = 100

The Current 9 Days Moving Average will be = 100

In this way the average price will change or move the next day by adding price of the current day and removing the price of the 10^th day from the calculation. Then a line will be drawn on the chart connecting the average prices, which is the Moving Average line.

This is the 9 Day Simple Moving Average formula. There are two types of moving averages commonly used; those are Simple Moving Average & Exponential Moving Average.

Simple Moving Average

Simple Moving Average (SMA) is calculated by dividing the total price of a certain period or days with the number of days (period) as calculated above.

Exponential Moving Average

Exponential Moving Average (EMA) gives more weightage to the recent prices than the previous prices while calculating the average price. It gives more importance to the current price and less importance to older price data which better picture of the current trend. Therefore traders and analysts give more preference to the Exponential Moving Average. Its calculation method or formula is slightly tricky but we don’t have to calculate these, the trading platform software will automatically calculate and put it on the chart.

The period of moving averages calculation depends upon the time frame of the chart and which moving average we are using. If we are using a 9-Moving Average on the 1-Day time frame chart (1-day candle chart in which every candle shows price data of one day) then it will calculate data of 9 days and if we use it on the 1-Week time frame (in which every candle shows price data of one week) then it will show average price of 9 weeks.

How to add Moving Averages on the chart

To add moving average on the chart open and login to your trading platform or broker’s app (here we are using Zerodha’s web platform)

Open your chart then click on studies or the fx button. You will see a long list of various indicators.

In the search bar type moving average and select it from the below list.

Then the setup window will appear, type the period of the moving average like 20 or 50 as your choice.

If you want to change select the type either Simple or Exponential.

Select the color of the moving average line.

Click the Done button to complete the setup and you can see the moving average on your chart.

You can add multiple moving averages one by one in this process, but you should use different colors for all of them to easily recognize them.

20-Simple Moving Average on the 1-Day time frame chart is called 20DMA or 20DSMA and if we use 50-Exponential Moving Average on the 1-Day time frame then it is called as 50DEMA.

There are 3 moving averages and mostly the exponential moving averages are commonly used, those are 20 Day Exponential Moving Average (20DEMA), 50 Day Exponential Moving Average (50DEMA) and 200 Day Exponential Moving Average (200DEMA).

How to trade using Moving Averages

Moving Average Indicator to identify trend and momentum

Moving Average lines are used to analyze the trend and momentum of the price which also gives buy and sell signals. Some traders generally day traders use 9-Moving Average and 14-Moving Average to analyze short term trend and change in momentum of the price.

If the price is moving below its moving average then it is in bearish trend and if the price is above its moving average then it is bullish. If a shorter period moving average is at upper level of its longer period moving average then the stock is in bullish trend and if a shorter period moving average is at below of its longer period moving average then the stock is in bearish trend.

For example – when 20 Day Moving Average is at above the 50 Day Moving Average the trend is bullish if 20 Day Moving Average is below the 50 Day Moving Average the trend is bearish.

Moving Averages as support and resistance levels

Moving Averages are also good to identify the support and resistance levels of the price. Most of the blue-chip bullish stocks take support on their 20 Day Moving Average or 50 Day Moving Average.

Swing traders and positional traders prefers 20 Day Exponential Moving Average (20DEMA) & 50 Day Exponential Moving Average (50DEMA) to identify the short term trend and support levels. Which helps to identify the entry point and they take position when the price is at the support of the moving average or when the stock breakout it. If the price falls below the 50 Day Moving Average, it is considered as short term bearish; hence short term traders exit them or avoid these stocks.

Moving Average Golden Cross Over & Death Cross over

Traders use multiple moving averages to identify entry & exit points or buy & sell signals. If a short period moving average cross a longer period moving average from upper level and moves downwards then it is called as Death Crossover, it indicates a bearish trend and are taken as sell signal.

For example – when the 20 Day Moving Average crosses the 50 Day Moving average or 50 Day Moving Average crosses the 200 Day Moving average from upper level to downwards then it is a Death Crossover and a bearish signal.

 If a short period moving average cross a longer period moving average from lower levels and moves upwards then it is called as Golden Crossover, it indicates a bullish trend and are taken as buy signal.

For example – when the 20 Day Moving Average crosses the 50 Day Moving average or 50 Day Moving Average crosses the 200 Day Moving average from lower level to upward then it is called as Golden Crossover that is a bullish signal.

Moving Average to identify long term trend and valuation

Long term investors use 200 Day Moving Average to identify the trend and valuation of a stock. When price falls below the 200 Day Moving Average, it is considered as long term bearish. Some long term investors or traders exit the stock when it falls below its 200 Day Moving Average because it may consolidate below it for a longer period; they wait until the stock breakout over it to take new position. But good fundamentally strong shares if available below or near their 200 Day Moving Average are considered as good value buy. This strategy is called as the 200-day moving average strategy.

Conclusion

Although moving average indicators are used for various purposes and most of the indicators have moving averages included in it like MACD or Bolinger Band with some extra features added with it. But it is considered as a lagging indicator hence provides late information. Therefore traders use other indicators and Oscillators like RSI, MFI, Stochastic etc with moving averages for bettor analysis.

Disclaimer – In this chapter we have discussed the basic features for information and educational purposes only and not any recommendation. You should make proper analysis before making any decision and take professional advice if you need because investing in stock market is subject to market risks; there are a lot of factors which may affect the price movement. If you like our content please share it with your friends and thanks for visiting again.