A Beginner's Guide to Moving Averages
Cryptocurrencies are making headlines every day and overturning the fundamental concepts of finance. With crypto even being hailed as the future of money, it's no surprise that several million individuals are interested in cryptocurrencies. In fact, it was reported that over 100 million people owned cryptocurrency as of January 2021. Given the financial autonomy, incredible returns, and a slew of other perks that cryptocurrencies provide, everyone from private and institutional investors to large enterprises appears to be investing and trading crypto these days.
If you have also been hoping to jump on the crypto trading bandwagon, you definitely need to be aware of various analytical methods essential for crypto trading. Although cryptocurrencies are fundamentally different from traditional money, the principles that govern the cryptocurrency market's behavior are essentially the same as those that regulate other financial markets like the stock and commodities markets.
This article will introduce and cover the concepts of moving averages in crypto trading. The moving average is a popular indicator in all financial markets, including the crypto market. The primary purpose of a moving average is to smooth out price action over a certain period. Given how moving averages are a lagging indicator, it should be obvious that they are essentially based on previous price action, and therefore they lack predictive qualities.
What is a Moving Average?
A Moving Average (MA) is a type of technical analysis tool in trading which helps to smooth out price action and fluctuations in an attempt to make it easier to spot market trends. Unlike candlestick formations, one of the most common trading strategies that help crypto traders determine the price movement from one direction or another within a confined timeframe, moving averages help traders visualise the overall trend across the daily highs and lows of a particular cryptocurrency.
Moving averages are an extremely valuable analysis tool for crypto traders since they effectively break down the momentum of a particular crypto coin. The averages are typically represented in an easy-to-see format by a simple line that indicates where a coin’s price was and where the price is likely to go.
In its most basic form, the moving average is a simple line that shows the closing price of a cryptocurrency over a period of time. When setting up moving averages for technical analysis, traders are free to modify the number of periods they want to take into account. Typically, a period refers to a unit of time that is based on the timeframe you are observing on the chart.
For instance, if a crypto trader has a moving average for a period of 21, the moving average on an hourly chart will smooth the price based on the last 21 hours of data, while the moving average on a daily chart will be smoothed on the basis of the last 21 days of price action.
Types of Moving Averages
Moving averages are primarily of two types - simple moving average (SMA or MA) and exponential moving average (EMA).
- Simple moving average
The simple moving average is a technical indicator that calculates an asset's average closing price over time to determine its market performance for that time period and is usually calculated by producing an average of price data of chosen ‘n’ periods. For instance, a 50-day SMA would involve taking the average price of the cryptocurrency in the last 50 days and plotting the results on a graph.
The three most common simple moving averages you will come across are the 50, 100, and 200-day moving averages.
- 50-day Moving Average
A 50-day moving average shows short-term market confidence and is the most popular moving average type among swing traders because it accurately represents the market over a 24-hour period. Typically, price action above the 50-day moving average indicates that traders are in a short-term bull market, while price action below the 50-day moving average indicates that traders are in a short-term bear market.
2. 100-day moving average
100-day moving averages are medium-term momentum indicators that are characterized by market reversals or abrupt price shifts. Prices above the 100-day moving average, as in the 50-day moving average, are more bullish in the long run, while prices below this level are bearish.
3. 200-day moving average
The 200-day moving average is computed in the same way as the 50- and 100-day moving averages by adding the price action for the previous 200 days and dividing the result by 200. The biggest advantage of the 200-day moving average is that it provides traders with a bigger picture of how the market is performing. The 200-day moving average is a very crucial gauge for longer-term trends, and while it won’t tell you whether you should buy or sell an asset on a day, it certainly gives traders an indication of whether or not they should hold on to a cryptocurrency for a while.
Disadvantages of Simple Moving Average (SMA)
While simple moving averages are extremely reliable and easy to use and understand, this simplicity also happens to be their biggest weakness. Since all data points are assigned the same weightage, the outcome on each of these would be equal, which basically means that if traders get a price that is out of range, compared to other price points, this can alter the simple moving average line and provide traders with inaccurate results.
This can be easily illustrated with an example. Let the price action of a crypto on five days be $4, $5, $4, $3, and $20, respectively. If you calculate the simple moving average over these five days, the SMA line would then be centered around an average of $7.2. From this, it is obvious that drastic and major price fluctuations can greatly impact the averages.
Let us now look at the exponential moving average.
- Exponential moving average
The exponential moving average is not as simple as the simple moving average and uses a different formula that relies on more recent price data. Because of this, the EMA is usually quicker to react to recent events in price action than the SMA. This reliance on recent price movements also helps traders to get a better understanding of the direction of price momentum and helps them instantly decide whether they should enter or exit the market.
The exponential moving average is typically built upon a “linear weight” moving average whose calculation is rather complex due to the inclusion of an exponential multiplier. The exponential moving average is usually calculated in three steps:
- For the initial EMA value, a simple moving average is calculated first.
- Then, the weighting multiplier is calculated.
- And finally, each day's exponential moving average is calculated using price, multiplier, and the preceding period's EMA value.
Swing traders generally use between the 5, 10, 20, and 50-day exponential moving averages for their trades, and the 20 and 50-day EMAs are the most popular of all since they can instantly generate buy or sell signals.
Disadvantages of Moving Averages
The most obvious disadvantage of moving averages as lagging indicators is that since they are based on previous data, the longer the period they are plotted on, the greater tends to be the lag.
While short-term moving averages are quick and give instant results, such as a 10-day moving average, a 200-day moving average, in comparison, will contain lots of past data that will be slower in reacting to price action. As a result, a larger and longer price movement may be required for a 200-day MA, or even 100-day MA, to change course.
Common strategies for crypto trading using moving averages
If you’re wondering how to get started on crypto trading using moving averages, here are some things you need to know. First of all, it is important to determine the time period for trading. Typically, the length of the MA that you will be using would depend on each trader’s trading style. For example, short-term traders tend to use shorter moving averages while long-term traders and investors prefer a longer moving average.
Signals and Indicators
- Support and resistance
One of the most common applications of moving averages is in identifying trend direction so that support and resistance levels can be determined. A 50-day, 100-day, or 200-day moving average can operate as a support level in an uptrend, but it can also work as a resistance level in a downtrend.
Traders can use the slope of a moving average to define trends. A moving average that is sloping upwards suggests an uptrend, whereas a moving average that is sloping downwards signals a downtrend in your crypto asset.
Crosses are a popular indicator in moving average trading, in addition to being one of the most common trading strategies. To trade with crosses, traders should use two or more moving averages on their charts, with one MA being longer than the other. To keep the chart from becoming cluttered, most traders only use two MAs. If the short MA crosses above the long MA, this indicates a bullish trading signal, however, if the short MA crosses below the long MA, this gives a bearish trading signal.
Moving averages are a simple and reliable trading strategy that traders can use for crypto trading, and it is especially useful for beginners to crypto. Regardless of whether traders are day trading, swing trading, or investing, moving averages provide a clear indication of market direction and market sentiment. In addition, combining moving averages with other indicators such as candlestick formations and charting patterns will help crypto traders get a much better indication of how to trade successfully.
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