One of the most used; technical analysis indicators could not have existed without a moving average. In simple words, it smooths out the price data so as to extract the trends over a period of time.
What is moving average?
A moving average is essentially taking the average prices of an asset over a set time period that reduces short-term noise, and a trader can pay more attention to the general trend. This is the reason moving averages are part and parcel of every trader’s arsenal: they are simple and reliable.
It gives an easy reversal signal about the trend besides helping trace the direction of the trend, besides it is quite helpful for assessing the levels of support and resistance and figuring out the prevailing sentiment in the market. Thus, by smoothening price data by the help of MAs, a trader can clearly figure out a pattern and decide upon his decision appropriately.
What does a Moving Average Indicate?
A moving average is basically an average representation of the price an asset has undergone within a period. The moving average smooths volatility, and is useful for the identification of trend:
1. Trend’s Direction: It is from comparing the moving averages of the short term and the long term that is possible to determine the direction of the overall trend. If the price is above a moving average, then it gives a signal of, a bullish trend while if it is below the same it gives a signal of a bearish trend.
2. Trend Reversals: Crosses of the short-term moving averages above longer-term ones, such as 50-day versus 200-day MAs, typically represent a buy signal that reverses a downtrend. It may indicate an uptrend beginning if the shorter-term moving average crosses above a longer-term moving average.
3. Support and Resistance: MAs can be used as moving support and resistance levels. For instance, during an uptrend, a stock may find support around a rising MA, while in a falling market, the same security might be resisted by a falling MA.
Types of Moving Averages
There are several moving averages that analysts use while performing technical analysis. The following types are mostly discovered:
1. Simple Moving Average (SMA)
SMA Formula:
SMA = P1 + P2 + P3 + ⋯ + Pn / n
Where:
• P1, P2, P3, …, Pn stands for the price, closing or closing prices; set period often (10days, 20 days, and 50 days.)
• Indicates the count of periods while taking the mean average.
How SMA Works
Simple moving average calculates the average price of a security over some number of periods. Each period gets equal weight and the average gets recalculated with every new point added. If you calculate a 10-day SMA, you’re going to average the closing prices over the last ten days. The SMA is going to shift each time a new price point displaces the oldest data point in the window.
Example
Assume a stock has these closing prices for the last 5 days: 10, 12, 11, 13, and 14. Calculate the 5-day SMA as follows:
SMA = 10 + 12 + 11 + 13 + 14 / 5 = 12
What does it Indicate?
• Smoothed Data: The SMA smoothes out any short-term fluctuations and clearly depicts the overall trend.
• It is a lagging indicator. Since it involves getting prior prices to use in the calculation of SMA, the response is always lagged relative to the price actions. It lags behind moving rapidly in trending changes or direction change.
2. Exponential Moving Average
ExpMA Formula,
EMA = Pt × 2n+1 + EMAy × 1− 2n+1
Where:
• p as current price,
• EMAy as old exponential moving averages.
• N as number of periods.
The formula is recursive. The EMA for each day depends on the EMA of the previous day. The smoothing factor (2 / n+1) gives more weight to the recent prices.
How EMA Works:
The Exponential Moving Average is quite sensitive to any recent price fluctuations since it carries more weight around the latest price than the simple moving average would. Thus, it would represent great value in case a trader needed quick reaction to recent fluctuations in price.
If you are calculating the 5-day EMA, then the closing price from recent days will have more weight hence making the EMA a responsive indicator. Comparing with SMA, the EMA will be more volatile and its rate of change in response to movements in prices is faster.
What does it indicate?
• More emphasis on prevailing prices: The EMA responds quicker to changing prices hence providing earlier warning signs of change in trends.
• Suitable for Volatile Markets: Traders use the EMA if the market is volatile or needs more dynamic answers.
3. Weighted Moving Average (WMA)
WMA Formula:
This called weighted moving average, and the formula used is;
WMA = P1 × w1 + P2 × w2 + ⋯ + Pn × wn/w1 + w2 + ⋯ + wn
Where:
•P1, P2, …, Pn are the prices for each periods.
• w1, w2, …, wn are the weights for each price such that more recent prices receive higher weights.
How WMA Works:
While the SMA will used the same weights for each of the prices in the time series, the Weighted Moving Average will assign different weights to each of the prices. The older prices are less significant in the WMA than the most recent price.
Illustration:
For instance, for a 3-day WMA, the weights could be set as follows: Specifically, in the case of the most recent day, the MI values were 3, for the second day – 2, and for the third – 1. The prices of the last 3 days where 10, 12 and 14. The WMA would be
WMA = 10 * 1 + 12 * 2 + 14 * 3 / 1 + 2 + 3 = 10 + 24 + 42 / 6 = 12.33
What does it tell?
•More Rugged: WMA is less sensitive as SMA and EMA, and also not as smooth but acts more on the latest price changes.
•Useful in Short-Term Trading: As a matter of fact, the WMA is helpful in the more recent price action and trends within the shorter time frame particularly emerging from the more volatile sectors.
Examples and Applications of Moving Averages
1. Trend Detection
Moving averages are easy to apply, because one can simply look at it in terms of which direction the trend is going. The moving average goes up in case of an uptrend and, if the moving average goes down, then it’s a downtrend. For long-term trends, commonly used moving averages include 50-day and 200-day.
For example, think about the 50-day moving average-another way to describe that would be termed the 50-SMA. Once the price of the stock is above the 50-SMA, an upward trend arises; once it falls, the trend is a downturn.
2. Moving Average Crossovers
Perhaps the best-known application for the moving averages strategy is the usage of moving averages crossovers: namely that point at which a short-term average crosses a longer-term average:
• Golden Cross: Once short-term moving average say 50 days crossing above the long-term moving average like 200 days, so it brings positive signal showing maybe the trend may go in upside.
• Death Cross: Which becomes bearish signal while crosses below down this can also be said by considering it like- maybe direction towards the trend downwards.
3. Support and Resistance
It is dynamic support in an uptrend and becomes resistance in a downtrend. The most popular long-term levels in terms of watching for support and resistance probably would be the 200-day EMA. A stock that’s in an uptrend where it drops back down into the 200-day EMA, then recovers, it is acting as a support.
Conclusion
In a nutshell, Moving Averages is one way of evaluating prices and estimating their future movements based on the insight of traders and investors. It helps cancel short-period price movements while revealing the real trend prevailing in the market. Based on the time frame of the market, the strategies should be chosen accordingly by the traders.
• For smooth long-term trends, this SMA is a better option if the traders are not that concerned with rapid fluctuations.
• EMA is preferred for those who need signals to be more responsive and live. It provides more weightage to recent prices.
• WMA is the best for people who need balanced approach. It considers giving each period equal weight on its data.
The combination with other technical indicators increases the predictive accuracy. Therefore, knowing how these moving averages can be applied will create more insight and a better-informed decision that is made by a trader in varied market conditions. In the event that moving averages are applied right, they assist the trader on how to land the right target in the financial markets.
FREQUENTLY ASKED QUESTIONS
1. What are the 4 moving average strategies?
The four most widely used to move average strategies are as follows:
1. Moving average crossover: This type of strategy refers to a setup using two SMA of varying terms; an example of the set used will comprise the 50-day SMA and a 200-day SMA. For this case, when the 50-day crossover the SMA increases over the larger one termed to be Golden cross. This signal tells an individual to sell whenever the smaller-moving average declines more below the main SMA; therefore, the death Cross ensues.
2. EMA Crossover: This is quite alike to the SMA crossover system, only that this one use EMAs as opposed to SMA. –Because the EMA provides significance to the recent price more than the earlier prices it offers a much quicker response to the change in price. Short term EMA above the long-term EMA gives a buy signal while the vice versa, a sell signal.
3. Moving Average Bounce: The price hits a moving average either the 50-day or 200-day average; it acts as support or resistance, which is dynamic. A bounce from the moving average confers continuations in the existing trend.
4. MACD: This trading system is for one period, which usually consists of 12-day and a 26 day of Exponential Moving Average. Depending on the crossovers, if MACD line cross over the signal line upward it is considered a bullish signal and if MACD line crosses below the signal line then is considered a bearish signal.
2. What is the 3-period moving average?
A 3-period moving average is simply a calculated average of the last three period, where period could be in days, hours or other time frame. Probably, the simplest example of the computation of the 3-period SMA of the closing prices of a particular stock in the past three days is to find the sum of the closing prices of the security in the preceding three days and divide the result by 3. This shorter period is more sensitive to recent changes in prices than the longer moving average.
Formula for a 3-period SMA
SMA = P1 + P2 + P3 / 3
Where P1, P2, P3 are the last three closing period prices.
3. What is the moving average method?
Moving averages are a way of calculating the averages of data for a set number of periods, in an attempt to smooth out the fluctuations in order to discover the trend in data. The technique can be used with any type of time frame and can be calculated using formulas like SMA, EMA, or WMA. In trading, moving averages help to analyse the price movements, determine buy signals, and sell signals.
4. What is MA 7 in trading?
MA 7 stands for 7-period moving average. MA 7 is one of the moving averages, wherein one calculates the average value for the last 7 periods: days, hours, minutes. It is basically used for short term trade because it gives a very reactive view about short-term changes rather than MA over a long time period. Its usage will lead to identification of trends or short-term entry/exit point.
For example, if the following are closing prices for the past 7 days: 15, 16, 17, 18, 19, 20, 21 then the 7-period SMA is:
SMA=15 + 16 + 17 + 18 + 19 + 20 + 21 / 7=18.1
5. Which moving average is best?
There is no such thing as ‘the best’ moving average, only ones that are comfortable to a trader on a given strategy, time frame and risk appetite. The following are guidelines:
• SMA: It’s best for a long-term trader or someone wanting a smoother trend analysis since all data points carry equal weight.
• EMA: It is basically a moving average for the short time period or response-based trading system since more weight is assigned to the last prices, thereby reacting faster with the changes in price.
• WMA: It helps to assign specific weights to the various data points and therefore weight to more recent price action.
In general, EMA is considered more appropriate for active traders who require faster signals while the ‘SMA’ is used for long-term trend detection.