What is a Moving Average Indicator?
Moving Average is one of the simplest indicators used in trading and it shows the average price of a stock over time; it is constantly updated as new price information becomes available. This indicator is one of the most common tools of technical analysis and shows an ‘overall’ price direction, smoothing over short-term market deviations and price fluctuations.
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Why use a moving average?
The basic advantage of a moving average is the fact that it smoothes over ‘noises’ on a chart and shows an overall price trend. Such indicators are used to identify trading signals; in simple terms, ‘buy’ signals can be inferred when the price of an asset moves above the moving average indicator and ‘sell’ signals then happen when prices are below a MA. Sometimes a moving average can be interpreted as support and resistance levels, but more on this below.
Simple Moving Average (SMA)
A simple moving average just takes an arithmetic average of past closing prices over a certain time period. The main use of this indicator is observing a trend in the price of an asset and identify potential reversal points. The longer the time period of an SMA, the more short-term noises and market fluctuations are smoothened over. This is, as the name says, the simplest type of a moving average indicator used in trading.
Exponential Moving Average (EMA)
Moving average in itself is quite a simple metric and placed same importance to most recent and also older returns of a stock or an asset. That might be not exactly what you want in your analysis, especially if you are focusing on most recent price trend and short-term trading. Because of that, eToro provides an exponential moving average indicator which places more weight on more recent returns of the asset; that is also why it is often referred to as the weighted moving average indicator. EMA tends to be more responsive to price changes and like other moving average indicators is used to generate buy and sell signals for an asset. To plot an EMA on eToro you need to access the moving average tool and choose type ‘Exponential’ in the custom box, like shown on the image below.
EMA tends to spot price trends faster than SMA and is overall more price sensitive over short time periods. This also means however that it is fluctuates more than SMA and that sometimes may be harmful to your trading process. Note the difference between exponential moving average, shown in red, and a simple moving average indicators, shown in blue below. Neither of these indicators are better than the other and which one you should use depends on your trading strategy and the chosen time frame.
EMA is used in identifying a price trend and therefore ‘buy’ and ‘sell’ signals. It can also sometimes be interpreted as a support and resistance levels, where for instance the price would not fall below the EMA which therefore acts as a price ‘floor’ or the support level.
Moving Average Deviation Indicator (MA Dev)
This indicator shows how the price of an asset deviates from its moving average over time and the extent to which deviates is shown by the bars of a histogram. This indicator shows two bars, increasing and decreasing, which correspond to increasing and decreasing price periods accordingly. The default field on eToro is set to 12 candlesticks of closing price by default, as well as the time of the moving average, for example, simple, exponential, weighted an so on. A green or an increasing bar above the zero line on MA Dev would then indicate an upward price trend and a red or a decreasing one indicates a downtrend. When upward or downward bars begin to form on either side of the zero line, ‘buy’ and ‘sell’ signals for the strategy can be inferred.
Moving Average Convergence Divergence (MACD)
This moving average indicator is an oscillator momentum indicator that follows a price trend and just like other moving averages is used for technical analysis in trading. MACD line is created by taking the difference of two moving average indicators of different time intervals, a longer 26 and a shorter 12 day exponential moving average (these values are set by default but could be adjusted to the needs of your trading strategy on eToro), indicating both a price trend and its momentum. The resulting momentum oscillator moves upwards and downwards around the zero line as the two moving averages converge and diverge away from each other. MACD is used not only to identify a trend and its direction, but also its momentum and strength.
Traders can look for signals of bullish and bear markets on this indicator as well as market turns. When MACD crosses the zero line from below and moves upward the asset can be considered to be in an uptrend (a ‘buy’ signal) and when it crosses the zero line from above and continues downwards the market is said to be going down (a ‘sell’ signal). This is shown on the image below, with the MACD as the black line and signal line as the blue line.
What are the two different lines on this image then? The black line is the MACD itself, the difference between the 12 and 26 day exponential moving averages. The blue line is the signal line or the average series taken as the 9 day exponential moving average of MACD. The interaction of these two can be used as entry and exit signals of trades or as a confirmation to signals generated from different indicators/ trading strategies; such a signal can be confirmed when the MACD crosses over the 9-day EMA and moves into the direction of the price trend. In particular, when MACD crosses through the signal line from below, a bullish market is inferred and vice versa. Crossovers of lines are widely used as trend indicators but not really for momentum. To spot momentum you can also see a histogram with this indicator which shows the difference between the 9-day EMA (the signal line) and the MACD. It essentially shows how much MACD moves over or under the signal line; the histogram is positive or green when the line of MACD is moving above the signal line and vice versa, negative when MACD is below the line. It can also be used to interpret the most recent momentum of the price and the change in its direction. Higher momentum can be implied from the case when the histogram is above the zero line and a lower momentum from when it is below.
You can always change the default parameters of MACD on the platform to suit your trading technique. Setting a greater difference between the two EMAs makes the indicator more responsive to price changes of an asset. Also, making EMA shorter tends to generate cross overs in the signal line more often and faster. In case you want to use only the MACD line, you can set the same time period for both the EMA and MACD lines. Beware however, there are also dangers associated with this indicator: it can sometimes provide a signal for a price reversal while there is no reversal happening, often when a price of an asset is moving in a range for example, or in a triangle pattern.
Moving Average Envelope (MA Env)
There is one problem with moving averages: they can sometimes generate wrong trading signals, especially when markets are very volatile or ‘choppy‘. Drawing an ‘envelope’ around a moving average can mitigate the effects of short-term market noise. The ‘envelope’ lines are then drawn at a certain height or percentage above and below the chosen moving average indicator, set to 5% by default on eToro, but you can always customize this value to your trading. You might find certain similiarity between this indicator and Bollinger Bands as it is likewise indicative of overbought levels when the price of an asset reaches the upper band of the envelope and oversold regions when it approaches the lower band. Like other moving averages, MA Env may signal ‘buy’ and ‘sell’ signals, with the’buy’ signal generated when the price of an asset cuts through the lower band of the envelope and a ‘sell’ signal when it goes through the upper band, like shown on the image below.
Other types of Moving Averages on eToro
Besides all of the above common moving average indicators on eToro, you can always customize your simple moving average. For instance, you could consider a triangular moving average, which is a simple moving average which puts on more weight onto the middle part of prices over a given time interval. There is also a weighted Welles Wilder smoothing moving average, Hull’s moving average which likewise smoothes price movements by removing lags, VIDYA (volatility index dynamic average) that adjusts its speed according to volatility of an asset and so on. There is always a suitable indicator for your trading approach on eToro!
Hopefully now you have a better understanding of the different types of moving averages and how they can be used in your trading process. Beware of the capital loss risks associated with trading, as well as be careful with interpreting the signals of indicators. Enjoy using the eToro platform and best of luck!
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