A moving average is an indicator derived from the average price of a security over a specified period of time and is applied to charts to follow market trendsas securities move up and down. In addition, support and resistance levels (where the price of a security reversed its upward or downward trendin the past) can sometimes be established by monitoring moving averages over time; these points are then used to makebuy or sell decisions. However, moving averages are rarely effective as standalone tools because of at least seven disadvantages.
Key Takeaways
- A moving average is a technical charting indicator based on averages of past price movements.
- Common moving average time frames include 20, 50, and 200 days.
- Moving averages are used to identify trends and potential support/resistance areas.
- Like most forms of technical analysis, moving averages are based on past price moves and do not forecast the future.
Moving Average Disadvantages
Moving averages are available with many charting applications and offer a quick, easy way to see trends in a stock, commodity, or market. Common time frames for moving averages include 20, 50, and 200-day moving averages. Technical analysts also use moving averages to identify potential changes in trend. For example, a "death cross" pattern happens after a stock has moved higher, begins to move lower, and the 50-day moving average crosses over the 200-day.
While moving averages are widely used by investors and traders alike, the indicators are far from perfect:
- Moving averages draw trends from past price information only. Like any type of technical analysis tool, chart indicators don't take into account changes in fundamental factors that may affect a security's future performance, such as new competitors, higher or lower demand for products in the industry, and changes in the managerial structure of the company.
- Ideally, a moving average will show a consistent change in the price of a security over time. However, since every asset has unique price histories and levels of volatility, there are no uniform rules that can be applied across all markets.
- Moving averages can be spread out over any time period and this can be problematic because the general trend can be different depending on the time period used. For example, what appears to be an uptrend using a 50-day moving average might be part of countermove in a downtrend that is reflected in the 200-day moving average.
- An ongoing debate is whether or not more emphasis should be placed on the most recent days in the time period (such as with exponential moving averages). Many feel that recent data better reflectthe direction the security is moving, while others feel that giving some days more weight than others incorrectly biases the trend.
- Some investors argue that moving averages (and other forms of technical analysis) are meaningless and do not predict market behavior. They say that the market has no memory and that the past is not an indicator of the future.
- Securities often show a cyclical pattern of behavior that is not captured by moving averages. That is, if a market is bouncing up and down a lot, moving averages are not likely to capture any meaningful trends.
- The purpose of any trend is to predict where the price of a security will be in the future. However, if a security is not trending in either direction, it doesn't provide an opportunity to profit from either buying or short selling.
The Bottom Line
Many traders and investors rely on moving averages to identify trends and support/resistance levels, but for an indicator to be effective, its function must be understood: when to use it and when not to use it. The perils discussed herein indicate when moving averages may not be effective tools, such as when used with volatile securities, and how they may overlook certain important statistical information, such as cyclical patterns.
Given the drawbacks, moving averages may be a tool best used in conjunction with other indicators and analytical methods. In the end, personal experience will be the ultimate indicator of how effective moving averages truly are for your portfolio.
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FAQs
The period length determines the sensitivity of the moving average, and using the wrong period length can result in false signals. For example, using a short period length like 10 days may be too sensitive for long-term trends, while using a long period length like 200 days may be too slow for short-term trends.
What is the 7 moving average? ›
A 7-day moving average is a short-term trend indicator. To calculate the 7-day moving average, you are only required to add the last 7 trading days' closing price of the stock and then divide it by 7. It will give you the 7-day moving average of the stock. Place the average on the price graph.
What is the main disadvantage of the moving average? ›
The Bottom Line
The drawback is that some of the data used to compute the moving average might be old or stale.
What is the 7-day centered moving average? ›
7-Day moving average=(Cp1+Cp2+Cp3+Cp4+Cp5+Cp6+Cp7)/7=416. To calculate the average for day 1, the 7-day moving average will average out the prices for the last seven days.
What are the pitfalls of averages? ›
During this video lesson, students will learn about three flaws of averages: (1) The average is not always a good description of the actual situation, (2) The function of the average is not always the same as the average of the function, and (3) The average depends on your perspective.
When should you not use a moving average? ›
Securities often show a cyclical pattern of behavior that is not captured by moving averages. That is, if a market is bouncing up and down a lot, moving averages are not likely to capture any meaningful trends. The purpose of any trend is to predict where the price of a security will be in the future.
What is the secret of moving average? ›
This is the core idea behind the moving average. It simply takes the past prices and divides it according to whichever moving average parameter that you've chosen. In this case, this is a 5-period moving average. If you take a 3-period moving average, it's just going to look at the last 3 numbers and then divide by 3.
What is the most effective moving average? ›
But which are the best moving averages to use in forex trading? That depends on whether you have a short-term horizon or a long-term horizon. For short-term trades the 5, 10, and 20 period moving averages are best, while longer-term trading makes best use of the 50, 100, and 200 period moving averages.
Why use a 7-day moving average? ›
The 7-day MA comes in handy for the following: Support resistance: The moving averages are used to double the support or resistance levels in a short period of time. This level helps traders decide their entry or exit from a particular trade. Price crossover: Moving averages are used to determine when to sell or buy.
What is better than moving average? ›
Because an exponential moving average (EMA) uses an exponentially weighted multiplier to give more weight to recent prices, some believe it is a better indicator of a trend than a WMA or SMA.
Cons of Using Moving Averages
Lagging Indicator: Since moving averages are based on past prices, they inherently lag. During fast moving market conditions or at the onset of new trends, moving averages may signal the entry or exit too late, potentially reducing profits or increasing losses.
How accurate is the moving average indicator? ›
But like any tool, it's not infallible. Moving averages are considered lagging indicators as they use historical data and react to price changes rather than predicting them. Therefore, they are best used in conjunction with other tools, indicators, and analysis techniques.
How do you find the 7 point moving average? ›
For a 7-day moving average, it takes the last 7 days, adds them up, and divides it by 7. For a 14-day average, it will take the past 14 days. So, for example, we have data on COVID starting March 12. For the 7-day moving average, it needs 7 days of COVID cases: that is the reason it only starts on March 19.
How many moving averages should I use? ›
Traders and market analysts commonly use several periods in creating moving averages to plot their charts. For identifying significant, long-term support and resistance levels and overall trends, the 50-day, 100-day, and 200-day moving averages are the most common.
What are the disadvantages of MA? ›
The advantages of Moving Averages include their ability to identify trends, predict future trends, and filter out noise. However, their disadvantages include their lagging nature and their tendency to generate false signals during periods of market volatility.
What is the problem with simple moving average? ›
If the data used are not centered around the mean, a simple moving average lags behind the latest datum by half the sample width. An SMA can also be disproportionately influenced by old data dropping out or new data coming in.
Should you buy above or below the moving average? ›
If the price is above a moving average, it can serve as a strong support level—meaning if the stock does decline, the price might have a more difficult time falling below the moving average price level.
