8 Using Moving Averages and MACD
A Moving Average (MA) shows the average value of a security's price over a period of time. As the security's price changes, its average price moves up or down. A MA is usually calculated using the closing price but can also be calculated on the basis of the opening, high, low or mid price. It is generally drawn on the same chart as the price.
One interpretation of a moving average is that it indicates the ‘fair value’ of a security as it reflects the price that the market considered fair over a recent period. Thus, it removes ‘market noise’ which may cause prices to rise or fall at any time. As a result, moving averages are very useful in identifying levels of support and resistance.
There are various types of moving averages, but simple and exponential (EMAs), where more weight is assigned to the most recent data, are the most common. A simple moving average is calculated by adding the closing price of the security for a number of time periods and then dividing this total by the number of time periods. An important element in the calculation is the number of time periods used.
The key is to find a moving average that will be consistently useful. The most popular long term moving average for major market cycles is the 200-day moving average. In the medium to long term the 50 day and 65 day are popular with 21-26 days used for the short term and 9 to 13 days for very short term. The 50 hour EMA often provides intra-day support or resistance.
A popular interpretation is to compare the relationship between a moving average and the security's price. In some setups, a buy signal may be generated when the security's price rises above its moving average and a sell signal is generated when the security's price falls below its moving average. However, a moving average is not intended to get you in at the exact bottom nor out at the exact top. Rather, it is designed to keep you in line with the security's price trend by buying shortly after the price bottoms and selling shortly after it tops.
Another use is to compare two moving averages and to identify a buy or sell signal when a fast moving average crosses above or below a slower one. This indicates the trend.
A moving average may also be calculated on an indicator. Indicators that are especially well-suited for use with moving averages include the MACD, ATR, Momentum, and Stochastics. Whipsaws i.e. false signals, can also be reduced, at the expense of slightly later signals, by plotting a short-term moving average on an oscillator such as the RSI.
Indeed, the MACD (Moving Average Convergence/Divergence is a trend following momentum indicator that shows the relationship between two moving averages of price. It is calculated as the difference between a 26-day and 12-day exponential moving average with a 9-day exponential moving average, called the signal line, plotted on top of the MACD to show buy or sell opportunities. The difference between the MACD and the signal line is often plotted as a histogram.
There are three popular ways the MACD is used in set-ups:
In summary, moving averages are among the easiest of technical indicators to understand, particularly for someone new to the subject. They are also among the most useful and moving averages, along with some closely related indictors such as MACD and Bollinger bands, can be a firm basis or a trading system.