A moving average on a trading chart is an indicator which can help reveal patterns in a market which wouldn’t otherwise be visible with a candlestick chart alone. Using the correct moving average can reveal other signals such as head and shoulders or cup and handle formations.
What is a moving average?
A moving average is created by plotting the path of an asset’s price based on the average price over a set number of days. This creates a smoother version of an otherwise volatile movement, making it a valuable tool for trading cryptocurrency. For this simple example, we’ll use a 5 day moving average to explain how it works.
In the infographic above, we can see 2 lines. The yellow line is the daily price and the blue line is the 5 day moving average. For this example, the prices have been simplified for demonstration purposes. A 5 day moving average can only start once there are 5 days’ worth of prices available to calculate the first average. The price on the first day displayed is 7, the next day, it moves to 8 and stays there for 2 days. On the fourth day, the price jumps to 11 and rises to 12 on the fifth day. So 7+8+8+11+12 = 46 and dividing that by 5 to get the average gives us 9.2. Therefore, the first point plotted on the moving average line is 9.2. To find the next point on the moving average line, we find the sum of days 2, 3, 4, 5 and 6 before dividing it by 5, and so on.
Notice that the yellow price line is far more erratic than the moving average line. This is because a moving average is based on past prices, making it a “lagging” indicator. The higher the number of days that the averages are calculated upon, the longer it will take for the moving average to react to sudden market movements. So a 200 day moving average will be much smoother than a 20 day moving average and the 20 day will oscillate above and below the 200 day.
How to use a moving average in crypto trading?
A moving average can indicate whether an asset is overbought or oversold. This can be a valuable tool when trying to decipher in which direction a market will move. If the moving average is above the current price, the asset is overbought. This suggests that the price is likely to cross back down towards the moving average line. The greater the space between the 2 lines, the more overbought the asset is. Using moving averages alone to influence investment and trading decisions is risky as there can be periods of sideways action where the market is more unpredictable. A way to make the moving average more reliable is to use a pair of them calculated by different timeframes, for example the 20 day and 200 day moving averages, and use the difference between the 2 to analyse the market closer.
Moving averages can allow traders to see patterns and trends on a trading chart which they wouldn’t otherwise be able to see among the market volatility. This is one of the most powerful tools in trading when used in conjunction with a candlestick chart as it visualises when a market is overbought or oversold. All technical analysis tools though, work best when used in conjunction with one another. One of the most popular technical indicators traders can use for analysis is the MACD (Moving Average Convergence Divergence), which relies heavily on the concept of a moving average. There are countless other indicators which make moving average signals stronger, one of the most reliable being Bollinger bands.
As always, the only way to become a better, more consistent trader is to educate yourself on any technical analysis tools you can and then use them in real world situations. Try “paper trading” where you use these tools to make trading decisions but instead of actually placing the trade, write down the details to see if your trade would have come in. Once your success rate is at a comfortable level, you can then start trading for real.