Stocks markets experience wild swings and trend reversal very often. In such a case, a trader may find it extremely difficult to find the right price to enter or exit a stock/commodity. To overcome this, along with fundamental analysis, majority traders, for active trading rely on technical analysis. Amongst a plethora of tools and techniques available, moving average is the simplest and most widely used.
So, what is a moving average? What is its significance? Let us find out.
The article covers:
- What is the moving average?
- Why is it called ‘moving’?
- Types of moving averages
- Using moving average to identify trading opportunities
- Pros of using moving averages
- Downsides of using moving averages
What is the moving average?
Moving average is the most common time-tested technical indicator used for price analysis.
It picks up the price for any underlying security across several data points and averages them to arrive at a median price. Thus, the moving average primarily ensures that it smooths out the otherwise fluctuating price of securities over a time period.
Moving average is a technical tool that can help access support and resistance levels for traders who need to regularly plan their entry and exit from various assets like stocks and commodities. Note that it is a lagging indicator as it uses past information of the security.
Why is it called ‘moving’?
It is called ‘moving’ average because it is constantly re-assesses as new data points are found. Look at the below example to understand better.
Suppose Stock V Ltd’s closing price for five days of a week is 100, 102, 108, 106, and 104, respectively. This leaves us with a 5-day moving average of 104.
Now, when we move on to the next week, and the price data for the first two days of the following week is available, which we assume is 105, and 100, then the 5-day moving average indicator will automatically ignore the first 2 data points of the first week, i.e., 100, and 102. Instead, it will consider the new data points for the calculation of the 5-day moving average.
Accordingly, the 5-day moving average will now be 104.6.
Types of moving averages
There are numerous methods to calculate a moving average, and quite possibly, you may get varying results with each of the methods. The two most preferred moving averages are-
- Simple moving average (SMA)
- Exponential moving average (EMA)
Simple moving average (SMA)
A simple moving average sums up the data points for a given time frame and divides them by the number of data points.
For traders, SMA is an indicator to identify entry and exit points.
Formula for SMA = (D1+D2+D3+………. Dn) / n
- Here ‘D’ is the data points
- ‘n’ is the number of data points
Exponential moving average (EMA)
Contrasting to SMA, which gives equal weightage to all the data points under consideration, the exponential moving average gives more weightage to recent data points than previous ones. The idea is to make the average more responsive to price changes. To enforce this, weights are assigned to all the data points. In addition, more weights are assigned to later data points than earlier data points.
Steps to calculate EMA
SMA is taken as the starting point here. Alternatively, the close price of the previous day could also be taken as the starting point.
Calculate the multiplier
It is calculated incorporating the formula: Multiplier = 2 / (Selected time frame + 1)
This brings us to the formula for EMA which is
(Price today* multiplier value) + EMA yesterday * (1-multiplier value)
Using moving average to identify trading opportunities
Now that we’ve understood the core concept behind moving averages, let’s understand the significance of moving averages in trading.
Typically, a support point is considered a good place to enter buy positions, and a resistance point is a logical place to exit buy positions or enter sell positions.
The larger the moving average, the greater its impact on the support and resistance levels. Therefore, larger moving averages are used as long-term indicators, while smaller moving averages say a 14-day moving average, are used as short-term indicators.
Short-term moving average lines crossing the long-term moving average lines from below is an indicator on the bullish side. It suggests the momentum is expected to continue. Likewise, a long-term moving average line crossing below a short-term moving average line is a bearish sign.
Pros of using moving averages
- Moving averages nullify random price variations.
- Since its application is simple, one can plot multiple moving averages on a single chart, making the interpretation even more profound.
- It’s very flexible; the entire calculation isn’t nullified with the arrival of new data points; the formula automatically adjusts for new data points.
Downsides of using moving averages
- Moving averages don’t work for a sideways market, hence it is not something you can rely on at all times.
- Moving averages don’t consider the impact of price changes from news, events, management changes, seasonal changes, financial results announcement, etc.
- It tends to overlook complex relationships in data. Also, it doesn’t consider the impact of future changes like demand and supply, changes in competition, changes in the industry, etc.
Moving average is a simple indicator to understand the average price movement of a stock or security. The worth of moving average as a technical indicator is amplified when identifying areas of support and resistance. Moving averages, though used widely, may not rightfully gauge price movement every time. Therefore, it is paramount to understand the various nuances of moving averages and use them along with other technical indicators for a better trade.
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