Technical Indicators – Moving Averages

Moving Average Basics

Moving averages are very simple technical indicators and arguable one of the most important
in our trading systems. This guide will give you an overview of each moving average type and
how each moving average type is calculated. Don’t worry about learning the equations, just
understand what effects changing from simple, weighted and exponential moving averages
has on the charts.

Moving Average Types

Simple Moving Average (SMA)

The calculation for a 10 day SMA is as follows, calculated from most recent price (1) to oldest price
(10):

𝑃𝑟𝑖𝑐𝑒1 + 𝑃𝑟𝑖𝑐𝑒2 + ⋯ + 𝑃𝑟𝑖𝑐𝑒9 + 𝑃𝑟𝑖𝑐𝑒10

𝑆𝑀𝐴1 =
10

Note that the SMA can also be calculated using different time periods. For example, if you
wanted to calculate a moving average over 10 hours, simply add each price every hour for 10
hours and divide by 10 hours. The effect this has on system performance is discussed in more
detail later.

The chart below shows how changing the time period (in days) effects the SMA. As you can
see the 100 day SMA is slower to react as it still “remembers” the prices 100 days ago which
lags further behind than more recent price action. On the other hand, the 10 day SMA only
has price data for the last 10 days, and so reacts very quickly and ‘hugs’ the current price
action more closely.

100 SMA

50 SMA
10 days

10 SMA
Price 10
Price 1

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Weighted Moving Average (WMA)

The weighted moving average places more importance on recent prices as opposed to the
prices in the past.

The calculation for a 10 day WMA is a bit more complicated. The most recent price is
multiplied by the final number of days in the chosen time period. The oldest price is always
multiplied by 1, as it is the first price in the moving average calculation. These weighted prices
are then divided by the sum of the weighed factors. This calculation is show below:

𝑃𝑟𝑖𝑐𝑒1 𝑥 10 + 𝑃𝑟𝑖𝑐𝑒2 𝑥 9 … 𝑃𝑟𝑖𝑐𝑒9 𝑥 2 + 𝑃𝑟𝑖𝑐𝑒10 𝑥 1

𝑊𝑀𝐴1 =
10 + 9 + ⋯ + 2 + 1

Due to an increased importance being placed on the most recent prices the WMA moves a
lot faster than the SMA. The WMA will always be close to the current price than an SMA.

100 WMA
10 days
50 WMA

Price 10
Price 1 10 WMA

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Exponential Moving Average (EMA)

Like the weighed moving average the exponential moving average places more emphasis on
the most recent prices.

The exponential weighted moving average is the most complicated calculation of all. The
example below is for a 10 day EMA:
2 9
2 2 2
𝑃𝑟𝑖𝑐𝑒1 + (1 − ) 𝑥 𝑃𝑟𝑖𝑐𝑒2 + (1 − ) 𝑥 𝑃𝑟𝑖𝑐𝑒3 + ⋯ + (1 − ) 𝑥 𝑃𝑟𝑖𝑐𝑒10
𝐸𝑀𝐴1 = 10 + 1 10 + 1 10 + 1
2 9
2 2 2
1 + (1 − ) + (1 − ) + ⋯ + (1 − )
10 + 1 10 + 1 10 + 1

You can see from the charts that the WMA and EMA are extremely similar. Therefore the
complexity of an EMA usually does not justify using it over the WMA or even an SMA with a
shorter time frame.

100 EMA

10 days 50 EMA

10 EMA
Price 10
Price 1

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How to use moving averages in systems trading

Moving average crosses

The chart below shows how to use a moving average cross method to enter and to exit a
trade. The moving averages here are a 10 day SMA (blue) and a 50 day SMA (red). This simple
trading system works as follows:

1. Enter a trade when:

a. The fast 10 day SMA crosses above the slow 50 day SMA for a buy trade.
b. Enter a trade when the fast 10 day SMA crosses below the slow 50 day SMA
for a sell trade.
c. This creates a continuous trading system (i.e. you are always in a position).
2. To close do the opposite, exit the trade when:
a. The fast 10 day SMA crosses below the slow 50 day SMA for the previously
opened buy trade.
b. Exit the trade when the fast 10 day SMA crosses above the slow 50 day SMA
for the previously opened sell trade.
3. As you can see you will be in a buy trade, then a sell trade, then a buy trade … etc.

Note how at the final MA cross the price drops away quickly from the SMA. Therefore, you
only make a small profit in this trade. How could this be improved? Use an WMA, EMA or a
faster slow SMA (i.e a 30 day SMA).

Close buy trade

Buy

SMA cross

Sell
SMA cross

Price cross moving average

The chart below shows how to use a price cross moving average method to enter and to exit
a trade. The moving averages here is a 50 day SMA (red). This simple trading system works as
follows:

1. Enter a trade when:

a. The price crosses above the 50 day SMA for a buy trade.
b. The price crosses below the 50 day SMA for a sell trade.
c. Once again creating a continuous trading system.
2. To close, exit the trade when:
a. The price crosses below the 50 day SMA for the previously opened buy trade.
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 b. The price crosses above the 50 day SMA for the previously opened sell trade.

Close buy trade

Buy
Price cross SMA

Sell

Price cross SMA

Note how in this instance the price cross moving average system performs better than the
moving average cross system. This is because you exit the position 3 days earlier and lock in
more profit. We can conclude that the price cross moving average system is more “reactive”
than the moving average cross system. A more reactive system has advantages and
disadvantages.

Advantages:
1) You enter the trade at a better price, as the MA lags behind the price
2) Close out sooner, which means less of the profit is ‘given back’
3) Risk reward can be better, and stop loss can often be place nearer to the price action

Disadvantages:
1) You are in trades much more frequently. During periods of consolidation, this can
result in a greater number of losing trades. On the other hand, due to the slight lag on
an MA you are kept out of some positions.
2) Position may be closed out too early due to small price correction. Using an MA
smoothens out the price action, as opposed to relying on the price alone.

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Which MA combination is best?

The moving averages you use in a cross have a significant effect of the type of system you
trade. One popular combination to use is a 50 SMA and 200 SMA. When the 50-day average
and the 200-day averages cross, this is known as the ‘death cross’ and the ‘golden cross’. The
examples below shows the different MA combinations perform differently in different trading
periods.

50-day (red line) cross 200-day (blue line) (Market is CADJPY 2012-2013)

50-day cross below 200-day

Close buy position,

open sell position

Buy

50-day cross above 200-day

Notice how long the cross keeps you in the position for with the longer-term moving averages.
The move about lasts approximately 12 months, but is hugely profitable (depending on your
position size and stop loss positioning: See relevant guides for more information). Although
you enter slightly later, due to the longer-term MA, you also make sure to stay in the position
for most of the move.

It is important to note that no trend following system can open at the very bottom and close
out at the very top. However, significant money can still be made taking this middle chunk.

Below is the same market over the same period, for a 10-day (blue line) cross 50-day (red
line). Notice how you actually enter and exit at a much better price in this example, because
the 10-day is more responsive to price action. However, I have also marked up other positions
that would be entered following the system over the same period.

Whereas the 50/200-day combination only enters 1, profitable, position, (or 2 if you include
the final sell position) the 10/50-day combination opens 7 positions. The first position is
hugely profitable, however, the following 6 positions contain some losing trades. The overall

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period is still profitable, but during periods of consolidation (when the market is not trending),
it is easy to see how shorter MA combinations can be in and out of the market too frequently.

10-day cross below 50-day

Sell Sell

Buy
Buy Buy

Close buy position,

open sell position

Buy

10-day cross above 50-day

Match your trading to your personality

You have to adapt these to the type of trading style you believe best suits you. This might
involve some trial and error, so practice in demo mode and find out what fits you best. Longer
cross combinations mean you will be in fewer positions but you will hold them longer.
Similarly, shorter MA combinations mean you will be trading more frequently.

Time Frame

You can trade moving averages across any time frame and they a very common approach to
trend following. Again, make sure you match the time frame you trade to your lifestyle.
Personally, we trade the daily time-frame with our systems (Which are not directly an MA
cross, but have some similar features. More detail on these in later guides), because we prefer
to work 15 minutes each evening and that’s all. However, some people may prefer to trade
for several hours at a time on the 5 minute, 15 minute, hourly charts etc… using the same
principles.

An example below is 50/200 cross on the 5 minute charts. This is CADJPY again, between 7am
and midnight on the 17th of April 2017. Notice how the price action looks very similar to the
previous charts, despite being on a much smaller timeframe.

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 Sell
50 cross below 200

50 cross above 200

Close sell position, open buy position

How do we use Moving Averages?

Moving averages are the building blocks to many different systems. We don’t trade a pure
moving average cross, but have incorporated many of the features in to our systems. For
greater detail on this, go through our guides & videos on:

 Exit Strategies
 Filters
 Bollinger Bands
 Systems

Summary

1) There are 3 different types of moving average: Simple, weighted and exponential.
Weighted and exponential moving averages favour place more emphasis on more recent
prices
2) Moving averages are an incredibly powerful momentum indicator and can be used to
capture profitable trends
3) The combination of moving averages used has a large influence on trading style and the
way a system performs

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