Moving averages (MA) are simple technical analysis tools that smooth out price data by creating a simultaneously updating average price. Moving average strategies have gained in popularity for their ability of being specified for any time frame, effectively suiting both short-term and long-term investors.
The main takeaway points:
Moving average strategies effectively reduces “noise” that is generated from random short-term price volatility.
Can be constructed for any time period and in several different ways, incorporating multiple factors.
Simplifies the identification of trend directions and determines support and resistance levels.
The most common and widespread trading strategy utilizing moving average is “Crossovers”. Fundamentally, it involves applying two moving averages to a chart, one longer and one shorter. When the shorter MA crosses above the longer-term MA, it is a buy signal, indicating un upward trend. This is known as a “golden cross”.
However, when the shorter-term MA crosses below the longer-term MA, it is a sell signal, indicating a downward trend. This is known as a “death cross”. Both the buy signal and sell signal are represented in the chart below (courtesy of Investopedia).
The main drawback of moving averages is that they rely on historical data without any predictive function, this results in erratic and random results at times. If the price of the financial asset varies greatly day by day, the MA will generate multiple conflicting trade signals. Besides altering the time horizon to clarify the trend, the MA does not provide any further assistance. It is best to, in combination with the MA, consult alternative trend verifying indicators along with an analysis beyond technical indicators. This demonstrates how poorly moving averages work in dynamic markets and volatile conditions where MAs will not offer clear answers. This reinforces the importance of not solely relying on moving averages, but instead a range of technical indicators.