Moving average

In general, traders use moving average, abbreviated as MA, to identify appropriate trading ranges, price trends and analyze markets. MA focuses on determining the uptrends and downtrends in a market and allows traders or investors to get a signal when a trend is reversing. The average is calculated over a specific period of time, based on the time period the trader or investor chooses. There are advantages to using a moving average in your trading, as well as options on what type of MA you choose to use. It is one of the popular trading strategies suiting both long-term investors and short-term traders.

moving average definition

Moving average definition

Moving average is one of the most important indicators used in technical analysis that helps eliminate the fluctuation of the price so that the investor can get a better picture of the average price and the trend in the market. It is an indicator that converts market volatility into a smooth line while it is assumed to be one of the sequential price indices, as it shows the average stock price in the past. “Moving” word refers to entering new data into the MA calculations as the price moves, and therefore the mean is constantly changing.

Moving Average types

The two most popular types of MAs are the Simple Moving Average (SMA) and the Exponential Moving Average (EMA). They are often used to identify the direction of the market price trends or define potential support and resistance levels as two of the most important functions of MA.

Simple Moving Average (SMA)

The SMA is only an average of the stock price in the given period. In calculating the 10-day Simple Moving Average (SMA), the final 10-days closing prices are divided by 10. To calculate the 20-days moving average, we add the closing prices of a 20-days period and then divide by 20.

By the mean the formula for calculating the SMA is:

SMA= A1+A2+A3+……+An/n

Where n is the number of time periods and A is the closing price of each period.

Example of SMA calculation

Here is a simple example that shows how SMA is calculated. Prices data are collected over 7 days of a week and the SMA period is 5 days.

Imagine that daily Closing Prices are 11,12,13,14,15,16,17.

In case you want to calculate the SMA for the 5-day period you have:

First day SMA= (11 + 12 + 13 + 14 + 15) / 5 = 13

Second day SMA= (12 + 13 + 14 + 15 + 16) / 5 = 14

Third day SMA= (13 + 14 + 15 + 16 + 17) / 5 = 15

This helps to identify the downtrend and the uptrend on the chart at any given time. SMA smooths out volatility and makes it easier to view the price trend of particular asset or security. If the SMA points up, this means that the asset or security’s price is increasing. If it is pointing down it means that the asset or security’s price is decreasing. The longer the time frame chosen by the trader is, the smoother the simple moving average would be.

SMA limitations

There are different ideas about whether to emphasize recent days in the time period or emphasis on distant data. Some traders and economics experts believe that recent data about the market would reflect the trends that the security or asset is moving with currently. On the other hand, some state that historical data would tell nothing about the future direction of asset or security price trends. Based on the calculation of the SMA it relies too heavily on historical and outdated data considering the fact that the 10th or 200th day’s impact is important just as much as the first or second day’s impact.

Exponential Moving Average(EMA)

Exponential Moving Average (EMA), in contrast to SMA, focuses more on recent prices. Calculating the EMA is in the way that the closer the price is to the current price, the heavier the weight would be. In calculating SMA, only the average of a long series of data is calculated, but the exponential moving average takes more recent prices in computing.

By the mean the formula for calculating the EMA is:

EMA: {Close – EMA(previous day)} * multiplier + EMA(previous day).

Where close is the period’s closing price and initial EMA is the period’s SMA.

multiplier = [2 ÷ (selected time period + 1)]

For example for 10 days period the smoothing would be: S= [2÷ 10+1]= 2/11

Limitations of EMA

Although EMA takes recent data into account with higher weight, it still uses historical data as well. Many experts and traders in the market believe that historical data and past prices are useless in calculating current trends move and the newest data would indicate how the current trend would move.

sma vs ema
the blue line indicates SMA and the red line indicates EMA.

EMA vs SMA

As mentioned earlier simple moving averages (SMAs) and exponentials moving average (EMAs) are calculated in different ways. This computational difference makes the EMA respond faster to price changes while the SMA has a slower response to price changes. This is the key difference between the two types of averages.

Note that neither of these two methods is necessarily better than the other. In some cases, the Rapid reaction of EMA causes traders to mistakenly exit the trade immediately after seeing a temporary deviation, while a slower reaction of SMA keeps the trader in the trade and provides the chance of making more profit after the obstacles are over. At other times, this can be the other way around. The EMA speed makes future unpleasant changes in the graph appear faster than the SMA. Therefore, a trader who uses EMA will get rid of this damage faster. This leads to saving the trader’s time and money.

It is up to each trader to decide which MA is best for the particular strategy used. However many short-term traders use EMA because they want to be informed as soon as the price moves elsewhere while long-term traders tend to rely on SMA as these investors are in no hurry to move and prefer to make less change in their trades. It is notable that in the end, choosing any of these moving averages depends on the individual preference of each trader or the market characteristics.

As a beginner of using this strategy, you can try both EMA and SMA methods together to see which one helps you make better trading decisions.

EMA responds faster to market price changes, tends to be closer to Price Action, and also places greater emphasis on recent data about prices. On the other hand the SMA reacts slower, all prices data has the same value and no attention is paid to the recent ones.

Generally, when the price is above the EMA and SMA, the trend is rising, and when the price is below the EMA and SMA, the trend is decreasing. To verify this recommendation in a chart, past price behavior should be examined to provide a good insight into past trends and trend changes. So this is a general recommendation and other conditions and factors must be considered.

As mentioned earlier you as a trader or investor should try different MAs to see which one works best on the chart by changing its settings. Some moving averages may perform better on trading or investing some specific financial instruments like the popular stocks or cryptocurrency coins.

moving average resistance and support

Detect areas of resistance and support

Moving averages can be used as dynamic support and resistance levels. They are called dynamic since they are constantly changing depending on recent price action.

There are many investors and traders who look at MA as the level of support or resistance. These traders will buy when the price dips and tests the moving average or sell if price rises and touches the moving average. As moving averages in markets are the key to identify trends, they tend to work well in identifying balance levels or areas of resistance and support. By the mean MA performance in the uptrend is similar to the support line and in the downtrend is the same as the resistance line.

If the market trend is bullish, then the price will be above the moving averages. That is why moving averages will be market support. In the cases of a downtrend, the price will be below the moving averages. So the moving averages would be the market resistance. Note that when it comes to moving averages, you should not expect immediate or accurate reactions. So, instead of choosing moving averages as the exact location of support or resistance, consider them a range. For example, a 10 pip range around a moving average may be appropriate to select a support or resistance range.

It is important to say dynamic support and resistance are not as strong or as horizontal and diagonal support and resistance.

moving average timeframe

Moving average time frames

Depending on the trader or investor’s aim the length of MA may vary. There are three common time frames used for calculating MA by traders in the market which are listed below.

Short moving averages (5-20 periods): they are used often for short-term trends and trading. The 10-day MA is easiest to calculate since you can simply add the numbers and move the decimal point, so it is popular in short moving averages.

Medium moving averages(20-60 periods): traders or investors who are interested in medium-term trends would choose medium moving averages. The 50-day MA is quite popular as a medium MA.

Long moving averages(above 100 periods): finally long-term investors and traders in the market often prefer moving averages with 100 or more periods. The 200-day MA is popular in long-term moving averages.

To get better performance over long periods of time, you can use MA for 50, 100, or even 200 days periods. For example, using the 50 and 100 days MA, if the 50-day MA falls below the 100-day MA, it is called the “death cross” and is likely to have a significant downside. When the 50-day MA reaches above the 100-day MA, the “Golden Cross” is said to have occurred and indicates a price increase.

Highlights

Moving averages (MAs) are one of the most used and common tools of technical analysis.

SMA and EMA averages help identify trends by weighting gains.

Not any type of moving averages is necessarily better than others, depending on how traders use this factor in the market, one of which may work better under certain circumstances. Traders also have the option to use their own combination of moving averages that work best for them.

In any market, MAs with specific time periods may perform better and more properly. Using the opinions of experienced analysts as well as testing can help you find the best time frames.

If the price breaks above a moving average, the trend may be directing the upside or price stabilization. In these cases, the trader can identify the opportunity, or risk, by observing price movements along with the moving average.

Some traders determine the two or more moving averages with different lengths and time frames in their market price charts and then monitor their intersection.

Sometimes, passing the moving average offers good signals that can lead to great profit and in some cases, these can lead to weak signals.

Moving averages perform well when the price is going down or it is rising, but when the price is in a neutral trend, the MA is performed poorly.

Moving averages can be used to determine points of resistance and support levels.

This post is also available in: العربية (Arabic) فارسی (Persian)

Leave a Comment