All About Moving Averages.
We are all familiar with the concept of average, moving averages is an extension to this concept.
Moving averages are basically a trend following indicator that are used to define the current direction with a lag rather than to predict the price direction.
Moving average is a lagging indicator, which means most of the time events will happen first and impact the price movement on either side, depending on the impact of the event, which can be positive or negative. Moving averages are based on the past prices. These averages will smooth out the price data by filtering the noise that occurs in between the trading sessions and are mostly represented by sudden spikes.
Types of Moving Averages
The most popular types of moving averages
- Simple Moving Average (SMA)
- Exponential Moving Average (EMA)
- Weighted Moving Average
Calculation of SMA
Simple Moving Average: Just like we do calculation for average, we calculate SMA.
A 5-day SMA is the sum of the closing prices over the last five days divided by five.
As the name says, moving average, it is an average the moves. As the new data comes, old data will be dropped that causes the average to move along the time scale.
For example: Let us take last 5-day closing price of Stock X over the last 5 trading sessions
Similarly, as the new data comes in old data will be dropped and new data will be included in the calculation. As we get closing price data for 8th November, 5-day SMA will change as it will now include last 5 days will drop the 1st November data.
Calculation of EMA
A basic concept of technical analysis which states: market discounts everything. This means the latest price that you see on November 8, discounts all the known and the unknown information, which also implies that price on November 8 will be given more importance as compared to price data on November 1.
The Exponential Moving Average is based on this concept where the recent data is given more weightage and less weight to the old data. So when it comes to calculation of EMA, certain multiplier is applied to the recent data and by doing so, the recent data is scaled up and the oldest data gets the least attention.
We are not going into the detailed calculation of EMA.
Trend Identification Tool
Moving averages can be used to identify the trend.
The direction of moving average predicts an important indication regarding the trend direction. A rising moving average will indicate that prices are rising and signals an uptrend or the bullish phase. Declining moving average will indicate that prices are decreasing with each day signaling downtrend or the bearish phase.
The longer the duration of the moving average, the more will be the lag or the delay; shorter the moving average, less will be the delay.
20-day moving average will change fast when compared to 100-day and 200-day moving average. Short term moving average for e.g. 10-day and 20-day moving average is well suited for short term trading as price changes very quickly. Long term moving average for e.g. 100-day and 200-day moving average is well suited for long term trading.
They also form the building blocks for many other technical indicators and overlays, such as, Bollinger Bands, MACD, and the McClellan Oscillator.