A moving average seeks to identify the market’s trend by calculating an average of the market’s price over recent periods. By looking at the market’s price over the past n periods, the moving average smooths out the market’s price and cuts down on noise by ignoring day-to-day market fluctuations.

There are 2 factors to consider when it comes to moving averages:

  • What type of moving average?
  • How many n periods should the moving average include?

Types of moving averages

There are several types of moving averages, and the 2 most popular are the simple moving average (aka “sma”) and exponential moving average (aka “ema”). The simple moving average is more popular than the exponential moving average.

Simple moving average

The simple moving average = (sum of the market’s price over the past n periods) / (number of periods). Due to the way it’s calculated, the simple moving average puts equal emphasis on every n period’s price.

“N periods” can be anything. You can have a 200 day simple moving average, a 100 hour simple moving average, a 50 day simple moving average, a 26 week simple moving average, etc. As a general rule of thumb:

  1. 200 day simple moving average represents the market’s long term trend
  2. 50 day simple moving average represents the market’s medium term trend
  3. 20 day (or 10 day) simple moving average represents the market’s short term trend

Here’s an example of a 10 day simple moving average:

  1. Day 1 market price = $5
  2. Day 2 market price = $4.9
  3. Day 3 market price = $4.4
  4. Day 4 market price = $5.2
  5. Day 5 market price = $5.5
  6. Day 6 market price = $5.9
  7. Day 7 market price = $6.1
  8. Day 8 market price = $5.8
  9. Day 9 market price = $6.2
  10. Day 10 market price = $6.4

The sum of the market’s price over these 10 days is $55.4, and since there are 10 “periods”, the 10 day simple moving average = $5.54.

Moving averages can be used on any time period: hourly charts, daily charts, weekly charts, monthly charts, etc. We’ll be using daily moving averages throughout the rest of this post.

Exponential moving average

Unlike a simple moving average, an exponential moving average DOES NOT put an equal emphasis on every day’s price over the past n periods. It puts more emphasis on recent price and less emphasis on the market’s price from longer ago. As a result, an exponential moving average “hugs” the market’s price more closely when the market is trending.

How traders use moving averages

There are many ways to use moving averages when trading.

  1. Trend following strategies
  2. Mean reversion strategies
  3. Trend filter strategies