Understanding Moving Averages and the MACD
Technical analysis focuses on charts to understand trends and identify the best points to buy or sell. It doesn’t take any macroeconomic, social or geopolitical factors into account, as these are included in fundamental analysis . An experienced trader will use both to plan their trade. In a previous lesson, we discussed ranging markets and the Relative Strength Index , which helps you identify overbought or oversold instruments. In this lesson, we will cover another indicator. Specifically, we will discuss Moving Averages and the MACD.
Moving averages are simple line charts that track how the average price changes over a specified period of time and they’re useful because they show you the trend in the simplest way possible while removing all the noise from short-term fluctuations. There are many different types of averages but most traders use these two:
- SMA (Simple Moving Average): Each average is calculated by adding the 5 most recent closing prices and dividing by 5. You can then connect the dots against each day and you have your line. It’s straightforward, simple to understand, great for ignoring erratic price moves but probably best suited to traders that like to hold on to their positions for longer as SMA may take more time to reflect trend reversals.
- EMA (Exponential Moving Average): The calculation is based on a complex function that gives more weight to recent price points. The EMA is great for traders who want to enter and exit positions quickly because it’s more sensitive to price changes. However, this sensitivity is also its main disadvantage: every price change will be reflected in the EMA which could lead you to move fast and then regret it when the market corrects itself.
How can I use moving averages in my trading?
First of all, choose the right moving average and period based on your trading style. We’d encourage you to stick with the most popular options (SMA and EMA) because these are used by most traders and markets are about momentum . If you look at the same thing that other traders see, you will move in the same direction so you will be riding the trend.
The MACD (Moving Average Convergence Divergence) is an indicator which you can take into account, alongside the RSI. It tracks the relationship between two moving average prices and it’s calculated by subtracting the 26-day EMA from the 12-period EMA. Once you have the MACD line, you also plot the signal line, which is the 9-day EMA of the MACD. The relationship between these two lines, triggers trader activity:
- When the MACD crosses above the signal line, it’s a bullish indication so you should consider buying.
- When the MACD crosses below the signal line, it’s a bearish sign which prompts traders to sell
- When the instrument’s price diverges from the MACD, you should consider the possibility that it’s oversold or overbought and a reversal is due
As with all indicators, their main limitation is they assume the price will continue to move in the same pattern. Before proceeding with a trade, you may want to confirm your prediction with different indicators, e.g. MACD and RSI. Also, you should be aware of the limitations of technical analysis and you should keep an eye out for figures and reports that could take the market in a completely different direction.
Bitesize basics
- Moving averages plot an instrument’s average price over a period of time. The most popular ones are SMA, which tracks the average closing price, and EMA, which places more weight on some prices depending on how recent they are.
- SMA moves slowly, which means it removes the noise from short-term price fluctuations but it can also delay your decision making. EMA is more sensitive to change but it may lure you into hasty decisions.
- MACD is an oscillator which can signal the direction the market is moving towards. It’s a useful indicator but it should be checked against other indicators.
- Always bear in mind that technical analysis ignores macroeconomic factors.
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