Use 1: Predicting Future Prices
One of the most potent uses of moving averages is their ability to anticipate future prices. By analyzing historical data and past price movements, the moving averages can suggest potential future trends. This method works on the principle that current prices typically follow historic patterns, thus if the prices have consistently risen or fallen for a specific period, it’s likely they will continue on the same trajectory. It is critical to outline, however, that while this can be a useful predicting tool, it should only be used as a guide, and traders should always be alert to sudden market fluctuations.
Use 2: Identifying Support and Resistance Levels
Another invaluable usage of moving averages is their capability in outlining support and resistance levels. A support level is the price point where the demand is strong enough to prevent the price from declining further. On the other hand, a resistance level is the price point at which selling is considered robust enough to prevent the price from rising further. Given that these levels are a standard strategy in technical analysis, having a tool such as the moving averages that can visually present them on a chart is an asset for any trader or investor.
Use 3: Ascertaining Market Trends
Market trends are fundamental indicators for traders and investors, and moving averages play a critical role in determining these trends. The simplicity of moving averages makes them a formidable tool for visualizing and capturing trends in a single line. For instance, if a moving average line is rising, the trend is considered bullish, meaning it’s an excellent opportunity to buy. On the contrary, if a moving average line is dropping, the trend is bearish, which is an optimal time to sell.
Use 4: Identifying Trading Signals
Trading signals are essential in guiding investors when to buy or sell a particular security in a market. Moving averages can generate these signals through ‘crossovers.’ A crossover occurs when two moving averages, one short-term and one long-term, intersect. For instance, when the short-term moving average (e.g., 15-day moving averages) crosses above the long-term moving average (e.g., 50-day moving average), it generates a bullish signal, indicating it’s time to buy. Conversely, when the short-term moving average crosses below the long-term moving average, it’s a bearish signal, suggesting it’s time to sell.
Use 5: Enhancing Other Trading Systems
Moving averages can also increase the effectiveness of other trading systems and tools. They do this by smoothing out price data, thereby reducing market noise and revealing the underlying trend. This makes it easier for traders to spot market patterns and better use other predictive tools such as Bollinger bands, MACD, or Relative Strength Index (RSI). For example, adding a moving average to a candlestick chart can help clarify the trend and make the chart patterns more apparent and easier to interpret.
