Moving Averages – Mastering Technical Tools
It is one of the simplest and most popular technical analysis tools out there – but exactly how much do you know about moving averages? Find out as we take you through all the key things you need to know, including what they are and how to use them.
In this handy guide, we will cast a closer eye on moving averages, examining the various different types of these tools that are easily accessible and available to traders of all experience levels, from beginners through to advanced investors. Read on to discover more.
What are Moving Averages?
Moving averages can be defined as an indicator that is commonly used in technical analysis as a method of calculating and identifying the trend direction of a stock or determining its support and resistance levels.
They essentially map the average price of an asset over a certain time period, and they form the basis for other well-known technical indicators, including Bollinger Bands, Envelopes, Average Directional Movement Index (ADX), and MACD.
It is an entirely customisable indicator, meaning that an investor has the ability to choose whichever time frame they desire during the process of calculating an average, with the most common time periods being 15, 20, 30, 50, 100, and 200 days.
Types of Moving Averages
Simple Moving Average (SMA)
As its name suggests, this is the simplest form of moving average, as it calculates the average price of an asset by the number of time periods in that range, with a set of numbers being added together and then divided by the number of prices in the set.
The formula for calculating the SMA:
A1 + A2 + … + An
S M A = ––––––––––––––––––––––
a = Average in period n
n = Number of time periods
Exponential Moving Average (EMA)
This type of moving average places a greater emphasis and significance on the most recent data points, and is used to produce buy and sell signals that are based on crossovers and divergences taken from the historical average.
The formula for calculating the EMA:
E M At = [ Vt x ( s / 1 + d ) ] + E M Ay x [ 1 – ( s / 1 + d ) ]
E M At = EMA today
Vt = Value today
EMAy = EMA yesterday
s = Smoothing
d =Number of days
Weighted Moving Average (WMA)
This moving average indicator assigns a heavier weighting to more current data points, due to the fact that they hold greater relevance than data points emanating from the distant past. In the case of WMA, the sum of the weighting should add up to 1 (or 100%).
The formula for calculating the WMA:
Price1 x n + Price2 x (n – 1)+ … Pricen
W M A = –––––––––––––––––––––––––––––––––––
n x (n + 1)
n = Time period
Smoothed Moving Average (SMMA)
The aim of this type of moving average is to reduce noise, rather than reduce lag, and it is viewed as being similar to the SMA indicator. The SMMA takes all prices into account and uses a longer lookback period. Price fluctuations are removed, as the indicator reduces the noise and plots the prevailing trend, while old prices are not removed from the calculation. This indicator is often used to confirm trends and define areas of support and resistance.
Comparing SMA and EMA
When comparing the two main moving average types, the major difference between SMA and EMA is that the latter moves much quicker and with greater speed than the former.
This is because the EMA places more significance on the most recent price action points, meaning that when the price direction changes, it is able to recognise this movement much sooner than the SMA, therefore turning quicker when the price turns.
Regardless of the difference outlined above, moving averages are a simple, yet effective tool in the armoury of traders, as it helps them to visualise where price has been, as well as where the price might be moving to next.
How to Use Moving Averages
When it comes to using moving averages in day trading, it is important to remember that the longer the time period, the greater the lag. For example, a 100-day moving average will have a far greater amount of lag than a 10-day one because it contains prices for the past 100 days.
Also, moving averages over a longer course of time feature more widely-followed reference points, such as the 50-day and 200-day moving average figures, which many investors generally view as being important trading signals.
As a result of this, EMA is considered to be more accurate than SMA, due to the fact that it takes into account the varying degrees of importance of the numbers in a recent data set. EMA is regarded as a weighted average calculation, and is often favoured by traders who prefer its superior responsiveness to price changes.
While moving averages are simple to use, it is a solid tool that provides traders with an effective solution when it comes to filtering out random fluctuations and smoothing out the price action.
Through gaining a proper understanding of moving averages and how they operate, market movers can utilise this technical analysis tool to their advantage by identifying trends and price momentum, with the ultimate goal being an improved return on their investment.