Moving Averages: Charting the Markets
Moving averages may be the most common type of indicator used for charting the markets. Like Bollinger Bands, they’re plotted on the same graph as the price bars and provide not only an indication of the trend of the market but also support or resistance barriers as price moves into the moving average lines.
Support and resistance are price levels in the market that price bars may have trouble moving through and therefore often bounce off of them.
Following the closing price
Each type of moving average has its own unique variation of how it calculates the average of closing prices over the past. For measuring trends, use the simplest of the moving averages, not surprisingly called the simple moving average (SMA).
The SMA is the average of the closing price for a certain number of bars. It’s called a “moving” average because this process is repeated with each new bar, thereby creating a line that continues to move forward with each new bar plotted on your chart.
Like most things in trading, moving averages work because a lot of people use them. The more people use an indicator and respond to it, the more it will have an impact on the movement of the market itself. It’s a self-fulfilling prophecy.
Trading moving averages
The most common moving average is the 50 SMA. The second most common moving average is the 200 SMA. Professionals have used these two moving averages for years.
Use the 50 SMA as the trend indicator on all your charts for two reasons:
It’s very popular, so masses of people respond to it.
The period of 50 bars fits the definition of trend, which is “to extend in a general direction.” Based on this definition, trend is a long-term move; therefore, you wouldn’t want to use a short-term moving average.
Moving averages are among the most simple of the trend indicators to use. Typically, the trend is considered up when the price bars are above the moving average and the moving average is angling up.
Trend is considered down when the price bars are below the moving average and the moving average is angling down.