Moving average: definition, types and uses  

How to start trading or investing using moving averages with us 

You can use the moving average indicator to trade or invest with us. When trading, you’ll speculate on a financial asset price rising or falling without taking ownership of the underlying. You’ll use derivative products like spread bets and CFDs to go long if you believe that it’ll rise or short if you think that it’ll fall. 

When investing, you’ll buy and hold an asset, taking outright ownership, with the aim of making a profit in the long term and selling it when the share price goes up. With us, you’ll use our share dealing offering to invest in shares, funds, and investment trusts. 

We’ve listed a few steps that you need to follow to open a position with us: 

1. Decide whether you want to trade or invest 
2. Choose your preferred market 
3. Create an account or practise on a demo 
4. Set your position size and manage your risk
5. Open your position and monitor your trade 

What is the moving average and how does it work? 

The moving average (MA) is a technical indicator used by traders to spot emerging and common trends in markets. It’s a mathematical formula used to find averages by using data to find trends and smooth out price action by filtering out ‘noise’ from random fluctuations. 

In stock market analysis, a 50 or 200-day moving average is most commonly used to see trends in the stock market and indicate where stocks are headed, although they don’t predict future price movements. The moving average is used in trading as a simple technical analysis tool that helps determine price data by customising average price. There are many advantages to using a moving average in trading, and they can be tailored to any time frame. Depending on what information you want to find out, there are different types of moving averages to use. 

In an uptrend, a moving average can provide support, acting as support and forming a base or ‘floor’ for price action. In a down trend, a moving average can act as resistance, creating a ceiling.  

How is the moving average used in trading? 

The moving average is used to spot trends, identify possible trading opportunities and to determine levels of support and resistance. If the price is above the moving average, it could suggest an upward trend and indicate it may be worth taking a long position. If the price is below the moving average, it could indicate a downward trend, and a short position may be a good option.  

Day traders often use the moving average to make quick decisions and help identify small market movements, whilst other traders look for longer-term trends.  

Types of moving averages 

There are two main types of MAs; exponential moving averages (EMA) and simple moving averages (SMA). They both calculate trends differently and provide distinct insights into market movements.   

Simple moving average (SMA) 

The SMA formula is calculated by taking the average closing price of a security over any period desired. To calculate a moving average formula, the total closing price is divided by the number of periods. 

For example, if the last five closing prices are: 

28.93+28.48 +28.44+28.91+28.48 = 143.24 

The five-day SMA is: 143.24/5= 28.65. 

Exponential moving average (EMA) 

The EMA is calculated by placing greater weight on the most recent data points. It can sometimes be referred to as the exponentially 'weighted' moving average. This is because EMAs react significantly to the most recent price changes. 

The most popular EMAs are 12 and 26-day EMAs for short-term averages, whereas the 50 and 200-day EMAs are used as long-term trend indicators. When used in conjunction with other indicators, EMAs can help traders confirm significant market moves and gauge their legitimacy. 

To calculate the EMA, first work out the SMA over a set time period.  

Once this is done, use the EMA formula.  

EMA= (Current Price−Previous EMA) ×Multiplier+Previous EMA 

Example: 

Let’s say the previous EMA is 28.50 

The current price is 28.80 

Period: 5 days 

Multiplier = 2 ÷ (5 + 1) = 0.333 

𝐸𝑀𝐴= (28.80−28.50) ×0.333+28.50=28.60 

So, the current EMA value is 28.60. 

SMA vs EMA 

Both the SMA and the EMA are commonly used formulas. Whilst the two are very similar, the main difference lies in how sensitive they are to price changes. The SMA provides a broad overview of overall trends whereas the EMA reacts more quickly to recent price changes so it can be better for spotting short-term momentum.  

Choosing whether to use SMA or EMA can depend on your trading approach. If you’re looking to identify broader trends, then the SMA may be your best option, but if you’re looking to respond to short-term market movement, EMA would likely offer better insight. Understanding how each one works can help you decide which one best fits your trading strategy. 

It’s worth noting however that whilst using MAs can be useful, that nothing in financial markets is for certain when using technical indicators, and things can change quickly. While MAs can be helpful and provide great analysis, they’re not a magic formula that can predict which way to trade, and the market could turn against you.  

Moving average trading strategies 

It’s rare that moving averages are used in isolation, and instead they’re usually combined with other technical indicators as part of a wider strategy. The three examples below are examples of moving average trading strategies that utilise multiple averages to identify entry and exit points. 

Trend trading with multiple averages 

A market that is highly trending will typically show an element of order in relation to moving averages. The chart below highlights that for an upwardly trending market, we should see the price trade below the short-term SMA, with the medium and then long-term averages above that. This would be inverted for a downtrend. 

When a market displays this form of orderly characteristic, it allows for a trending market following a trading strategy. Buying (uptrend) or selling (downtrend) at the nearest moving average would then allow traders to find entry points within this highly trending market. 

The EUR/GBP chart below highlights this technique, with the price turning back onto the bearish trend from the lower (20) SMA on a number of occasions. The push through the highest moving average (200) provided a signal that this trend is over. 

Please note that this approach can fail when markets reverse suddenly and it doesn’t guarantee profits.  

Golden/death cross

The moving average crossover method is one of the most commonly used trading strategies, with a shorter-term SMA breaking through a longer-term SMA to form a buy or sell signal. The death cross and golden cross provide one such strategy, with the 50-day and 200-day moving averages in play. The bearish form comes when the 50-day SMA crosses below the 200-day SMA, providing a sell signal. Conversely, a bullish signal comes where the 50-day SMA breaks above the 200-day SMA.

Please note that crossover signals often lag price movements and can generate false signals in ranging markets. Significant movement may occur before the signal appears. 

Mean reversion using bollinger bands

This strategy utilises the Bollinger band tool with the 20-day SMA placed within the middle of the bands. This technique can be used without the Bollinger bands, but using the bands provides some additional benefits. The idea behind this method is that even when we see a highly trending market, the price will often return to mean before pushing back in the direction of the trend. As such, the middle Bollinger band (the 20-day SMA) will often be utilised as support or resistance, providing a useful buying and selling tool.

The chart below highlights the strategy in action, with the price falling below the 20-day SMA on the top left, indicating the switch from bullish to bearish sentiment. From there on in, the reversion back into the 20-day SMA provided a host of profitable selling opportunities.

On this occasion, the upper Bollinger band would have been useful as a tool to place your stop loss above. Alternatively, utilising the prior swing high would have also provided a profitable trading strategy. The dotted horizontal lines signal where those swing highs are located.

Please note that Mean reversion assumes prices will return to average, but strong trends can continue far beyond expected levels, resulting in losses.