The moving average is a technical indicator that monitors price data by updating the current average price over a specified period continually. This tool is not useful for predicting trends or breakouts in the markets, but it does help to confirm trends in price movements. Traders also use this indicator to track and identify trends by smoothing regular daily price fluctuations.
The MAs move over specific time zones, such as 30 minutes, 20 days, or 40 weeks, depending on the time frame a trader decides to use. For example, a 20-day MA calculates the average price of a specific futures contract over the past 20 days.
Traders calculate the MA by adding the previous x number of periods and dividing the sum by the total number of periods. Usually, this indicator appears as a smooth curved line that provides a visual representation of an asset’s longer-term trend.
One of the advantages of using the MA in the futures market is that it helps both long-term and short-term traders set their positions correctly.
The importance of a moving average
A moving average helps to reduce uncertainty in the futures market by removing noise from the price chart. Traders look at the direction of the moving average to determine the current price movement. For example, when the price is in an uptrend, the moving average moves up; the reverse is also true. It also identifies a range market when the line moves sideways.
Moving averages also behave like support or resistance. For example, in an uptrend where a 100-day or 200-day moving average acts as a support level, the indicator stays under the price, which makes traders cautious about making a decision.
Types of moving averages
Moving averages come in different variations, with each having a specific objective. The type of MA used in the futures market doesn't matter as long as its value gets price data based on previous periods.
The most commonly used moving averages are:
- Simple Moving Average, or SMA
- Exponential Moving Average, or EMA
Simple moving average (SMA)
Traders calculate the SMA by adding the previous periods and dividing the sum by the total number of periods. Each time a new period occurs, the SMA moves forward, dropping the first data point and adding the newest one.
Exponential moving average (EMA)
The EMA calculation is similar to the SMA. The only difference is that the EMA’s newest price data points receive more weight. As a result, the EMA reacts faster to price data than the SMA.
Traders may decide to use just the SMA or hybrid MAs by mixing concepts from the SMA and EMA. For example, when plotting a 50-day SMA and 50-day EMA on the same chart, the EMA reacts more quickly to price change. This happens as a result of the extra weighting of the newest price data point.
Using moving averages in the futures market
Traders use MAs to provide insights into market behaviour in the following areas:
- Trend identification
- Pricing movement
- Support and resistance
Moving averages focus on trend recognition because they are formed linearly on pricing charts. For example, the smooth curved line of the MA is the visual representation of a trend's existence. If the MA is below the price, there is an uptrend; if it’s above the price, it signals a downtrend.
In the chart above, we see price reacting in an uptrend on a futures market.
In the chart above, we see price reacting in a downtrend on a futures market.
Traders use both MAs with multiple time frame contexts. The time frame traders go for determines the effectiveness of the moving average. Traders can use crossover strategy with price movement when analysing the futures market.
For example, when the short-term timeframe MA crosses above the long-term MA, it signals a buy. Traders also call this a “golden cross.”
However, when the short-term time frame MA crosses below the long-term MA, it indicates a sell. Traders call this a “death cross.”
Support and resistance
The location of an active MA indicates a critical technical level. Many traders view MAs as guides on entries and exits. In situations where the price crosses over an MA, it signals a shift in the market, which means the prevailing trend is over. Most traders are then enticed to enter the market in anticipation of a new trend.
The bottom line
Traders need to combine the EMA and SMA in addition to using them individually in the futures market to spot excellent trading opportunities.