Every keen-eyed investor and trader in a financial market makes his or her earnings by conducting intensive research and utilising crucial markers before every transaction. They are benefitted by processes such as technical analysis and the variety of indicators that help gauge the trends and movements within the market.
One such significant indicator, used by a variety of market participants, is the Moving Average. But what is Moving Average exactly? And how can you read and interpret it to make informed trading decisions? Let us explore the concept in detail.
What is Moving Average?
Moving Average is essentially a technical indicator that is calculated as the average of a given set of data. In terms of technical analysis, this data is typically the various price points of a security, such as stocks or commodities. The Moving Average is thus calculated by adding up all the values of the data points of the security and dividing it with the total number of data points.
The indicator is known as a ‘moving’ average since its value keeps changing as the data, that is the underlying price values of the stock, keeps changing over time. When taken over a given period of time, such as 10 minutes or a week, the Moving Average represents the average value of the price action that the security underwent within that duration.
Understanding Moving Averages As an indicator, the Moving Average meaning is determined by the past price values of a security. It presents an average price of the asset over a period of time. Therefore, it can act as a useful indicator of where its price direction is headed for the future. It smoothes the price action and gives traders a clear idea of the overall price trend of the security.
If the Moving Average for a security is angled upwards, its price values are or have recently been rising. This denotes an upward trend. On the other hand, a downward angled Moving Average denotes a fall in price or a downtrend.
Moreover, since Moving Averages closely follow historical price movements, they can also help in establishing support and resistance levels. Most traders will follow the Moving Average to see if the price is going towards it, bouncing back or breaking the established resistance/support level. They also help traders in identifying potential entry and exit points into certain securities.
The length of Moving Averages can be changed based on the individual objectives of the trader. Therefore, short-term trading can make use of short Moving Averages, such as those extended across 30 days. On the other long-term investments can make use of long Moving Averages such as those extended over 200 days.
Types of Moving Averages
While Moving Averages serve as useful indicators for almost all market participants, not all of them use the same form of Moving Average. Overall, Moving Averages can be classified into three major types:
- Simple Moving Average: The most commonly used form of Moving Average in technical analysis is the Simple Moving Average. It is calculated by taking the mean of a set of values (mostly, prices of securities) and dividing it by the number of periods. It can be calculated as follows:
(A1 + A2 + A3 + A4…An) / n = SMA Where n is the number of time periods and A is the average within a given time period.
The most common periods for Simple Moving Average Tracking are 8, 20, 50, 100 and 200 days or periods.
- Exponential Moving Average: This is a weighted form of calculating Moving Averages, whereby recent price values are given more weight than past price values. To achieve the accurate Exponential Moving Average Value, the trader must establish the Simple Moving Average Of the security prices first. This value then undergoes a formula that gives decreasing weightage to the average of each passing period. Exponential Moving Averages adapt better and faster to changing price movements than Simple Moving Average.
- Weighted Moving Average: This type of Moving Average assigns varying weights to different price points, with more emphasis on recent data. Unlike the Simple Moving Average, which treats all values equally, the Weighted Moving Average increases the influence of newer prices in its calculation. This approach provides a more responsive indicator to recent market changes, making it particularly useful for investors looking to capture short-term trends and react more quickly to the latest market movements.
Simple Moving Average (SMA) vs Exponential Moving Average (EMA)
| Aspect | Simple Moving Average (SMA) | Exponential Moving Average (EMA) |
| Sensitivity | Less sensitive, reflects long-term trends. | More sensitive, adapts quickly to recent price changes. |
| Usage | Ideal for identifying overall trends and long-term patterns. | Preferred for short-term trading and to detect early trend reversals. |
| Lag | Higher lag due to equal weightage of all periods. | Lower lag because of emphasis on recent data. |
| Best for | Long-term investors looking for stable trends. | Active traders who need to respond quickly to market changes. |
Calculation Details
SMA Calculation:
SMA = (𝑃1+𝑃2+…+𝑃𝑛) / 𝑛
Explanation:
The Simple Moving Average (SMA) is calculated by taking the arithmetic mean of a given set of prices over a specified number of periods. This method equally weights each price in the period, making it less sensitive to recent price changes compared to the Exponential Moving Average (EMA).
EMA Calculation:
EMA = 𝑃 × 𝐾 + EMA(previous) × (1−𝐾)
Where:
𝐾=2 / (n+1)
- P is the current price
- n is the number of periods
Explanation:
The Exponential Moving Average (EMA) assigns more weight to recent prices, making it more responsive to recent price changes. The smoothing factor K determines the weight given to the most recent price, allowing the EMA to react more quickly to price changes compared to the SMA. The EMA is thus more effective in capturing short-term price movements and trend reversals.
Advantages of Moving Averages
- Simplifies Price Data: Smoothes out price fluctuations to reveal underlying trends, making it easier to interpret market movements.
- Identifies Trends: Helps traders recognise bullish or bearish trends by observing the direction of the moving average line.
- Support and Resistance Levels: Acts as a guide for potential support and resistance areas, informing buying and selling decisions.
- Signal for Entries and Exits: When prices cross over the moving average, it can signal an optimal time to enter or exit a trade.
- Versatility: Applicable across different time frames and markets, useful for both short-term and long-term trading strategies.
Disadvantages of Moving Averages
- Lagging Indicator: Moving Averages are based on past price data, causing a lag that might lead to delayed signals for buying or selling.
- Limited Predictive Power: They cannot accurately predict future price movements, only smooth out past trends.
- False Signals: In volatile markets, Moving Averages can produce misleading signals, leading to potential losses.
- Not Suitable for All Market Conditions: They are less effective in sideways or choppy markets where price movements are inconsistent.
- Oversimplification: Moving Averages might oversimplify the market analysis, overlooking crucial factors like volume and market sentiment.
- Dependence on Length: The effectiveness of a Moving Average heavily depends on the chosen time period, affecting its predictive accuracy.
Conclusion
The Moving Average is a quick, straightforward and effective means for traders to develop an understanding of the current market trends. Since they are calculated by accounting for past price movements, Moving Averages are a popular tool for traders to predict future price directions before making a transaction. However, like all technical indicators, it is recommended that Moving Averages should be used in conjunction with other factors to form an accurate, overall analysis of the market opportunities.
FAQs
Are there any disadvantages to using Moving Averages?
Yes, Moving Averages lag behind the market, offer limited predictive power, can produce false signals in volatile markets, are less effective in sideways markets, and their accuracy depends on the selected time period.
How does a Simple Moving Average (SMA) differ from an Exponential Moving Average (EMA)?
An SMA averages a set of prices equally over a period, reflecting long-term trends. An EMA gives more weight to recent prices, making it more sensitive to recent changes and suitable for short-term trading.
What is the primary purpose of a Moving Average in financial markets?
- To indicate the average price of securities over a specific time period and identify trends.
How do Moving Averages help in determining entry and exit points for trades?
When the price crosses above a Moving Average, it can signal a buying opportunity; when it crosses below, it can signal a selling opportunity, helping traders time their entries and exits.
