Moving averages is one of the simplest and no doubt one of the most popular technical analysis indicators. It can help to smooth out price fluctuations and volatile swings. It is a trend-following indicator as it is based primarily on past price moves. Because of this, it has lagging tendencies. It will not forecast price moves. By the time the moving average catches up to the price move, the trader would have already missed the trade.
Nonetheless, shorter-term moving averages such as the 9-period or 10-period, 21-day period, 50-period are commonly used by traders for short-term trading trends. So, which period setting gives the best trading signals?
There is no simple answer to the question. It all depends on the type of trader you are – a swing or a day trader. And most importantly, the reason you are using the moving averages.
One of the reasons why moving averages tend to work is because of the self-fulfilling prophecy (SFP). Robert Merton, an American sociologist, and the founding father of modern sociology, first coined the term in 1948. A self-fulfilling prophecy occurs when an original false social belief leads to the masses acting in ways that objectively confirm that belief. In the financial arena, since so many traders are using moving averages to help with their trading situations, it can lead to its confirmations. In general, go with the crowd and only deploy the most popular moving averages to trade.
For short-term day traders, you need a moving average that is fast enough and sensitive enough to react to the rapid price changes. When it comes to the periods and the lengths, most day traders tend to use the 9 or 10 Period as a filter since this is very fast-moving. 20 or 21-period can also be deployed as a secondary moving average when used in conjunction with a moving average crossover trading strategy (i.e., golden cross-buy and death cross-sell). It tends to track the day-trading trends well. Some will also utilize the 50-period, but it may not be as sensitive as the shorter-term periods since it works best when identifying the intermediate-term trading trends.
For swing traders, you need a moving average that captures the short-to-medium term gains in a stock's move, typically over a few days to several weeks. The objective of a swing trader is to create a lot of small wins while at the same time minimizing the large losses. In the end, this will add up to significant returns over a short period. The 20 or 21-day period is a popular choice for swing traders since this period is sensitive enough to pick up trend shifts. The 50-day period is also a standard swing-trading moving average. Most swing traders consider this an ideal balance between not too short (sensitive) and not too long-term (late).
In conclusion, moving averages can be a multi-faceted technical tool that can be effective for different traders and investors. Remember, moving averages works because of the self-fulfilling prophecy. To be effective the appropriate period setting must match the type of trading and investing strategies. As with any technical indicators, it is best to use them in conjunction with other technical disciplines such as trendline analysis, pattern recognition, retracements, etc.
Enclosed below are some of the popular moving averages applied to US market indexes.