Moving Averages: Application and Limitations
This lesson defines the simple and exponential moving averages, explains their inherent lag, examines the limitations of crossover signals, and identifies the applications of genuine use.
Risk note: educational content only. This article is not financial advice, investment advice, or a recommendation to buy or sell any instrument. Trading leveraged products can result in losses greater than expected, and each reader should understand the risks before trading.
The moving average is the most widely used technical indicator and among the most frequently misapplied. It smooths price data over a specified period to reveal the underlying direction, and in doing so it necessarily lags the price. That lag is not a defect to be engineered away; it is the property that makes the indicator useful. This lesson defines the simple and exponential forms of the moving average, examines the trade-off between responsiveness and reliability, explains why crossover signals perform poorly in ranging markets, and describes the three applications in which moving averages are of demonstrable value.
Definition and calculation
A simple moving average, or SMA, is the arithmetic mean of the closing prices over the most recent N periods, recalculated as each new period closes. A 20-period SMA on a daily chart is therefore the average of the last 20 daily closes. An exponential moving average, or EMA, applies a weighting that declines exponentially with the age of each price, so that recent prices exert a greater influence on the value. The weighting factor for an EMA of N periods is 2 รท (N + 1), and the EMA consequently responds to a change in direction more quickly than an SMA of the same length.
The most commonly used lengths are 20, 50 and 200 periods. These settings have no special mathematical property. Their usefulness derives in part from the number of participants who observe them, since reactions in price are somewhat more likely at levels watched by a large proportion of the market. Both forms of the indicator are available as standard in MetaTrader 5 and can be applied to any instrument and timeframe.
Lag and responsiveness
Because a moving average is computed from past prices, its value always lags the current price. A shorter length reduces the lag and allows the average to track the price more closely, but it also causes the average to change direction in response to fluctuations that do not represent a change in trend. A longer length filters these fluctuations more effectively at the expense of a slower response to genuine changes in direction.
There is no setting that eliminates this trade-off, and the pursuit of one is a common error. The appropriate length depends on the timeframe of the analysis and on the function the average is intended to serve. An average used to define the direction of the higher-timeframe trend should be long enough that ordinary retracements do not cause it to reverse; an average used to identify the location of pullbacks within a trend may be shorter.
The limitation of crossover signals
A crossover occurs when a shorter moving average crosses above or below a longer one. On a chart of a strongly trending market, crossovers appear to provide clean and timely signals. In a ranging market, the same crossovers generate a succession of false signals as the two averages repeatedly intersect, and each false signal incurs the spread and any commission on both the entry and the exit. Over an extended period, the losses in ranging conditions frequently exceed the gains in trending conditions.
A trader who wishes to verify this should test a crossover system on a period of historical data in which the market was confined to a range. The result illustrates why crossovers are unsuitable as a standalone trigger and why a structural filter of the kind described in Lesson 9 is required before any crossover signal is acted upon. The demo account is a suitable environment for this exercise.
Applications of demonstrable value
Moving averages are of use in three applications. The first is as a directional filter: long positions are considered only while the price is above a long-period average, such as the 200-period EMA on the higher timeframe, and short positions only while it is below. The second is as dynamic support or resistance in a strongly trending market, where retracements repeatedly halt in the vicinity of an intermediate-length average and provide a location at which to seek entries in the direction of the trend.
The third is as a measure of whether a trend exists at all. The slope of a moving average summarises the direction of the underlying price series: a rising average indicates an uptrend, a falling average a downtrend, and a flat average indicates the absence of any trend, whatever signals a crossover may appear to generate. In each of these applications the average serves as a filter or a reference, not as a trigger. A moving average is not, on its own, a reliable basis for entering or exiting a position.
- Filter: trade only in the direction indicated by the higher-timeframe average.
- Reference: an intermediate average marks the area in which pullbacks may find support or resistance.
- Measure: the slope of the average indicates whether a trend is present.
- Not a trigger: a moving average should not be used as a standalone entry or exit signal.