What Is A Moving Average?
The moving average (MA) is a technical analysis indicator and a statistical tool, that follows the stock price to form a trend following indicator. It is a lagging indicator and they do not predict the price, but it defines the current direction of a stock.
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Types of Moving Averages
Basically there are four types of MA, which are simple moving averages (SMA), exponential moving averages (EMA), smoothed moving averages, weighted moving averages. Out of these the SMA and EMA are widely used ones.
Simple Moving Average (SMA)
The simplest form of moving average, the simple moving average (SMA) can be calculated by taking the mean of a stock’s opening prices, closing prices, highest prices, lowest prices. In other words, the prices in the case of securities, are added together and then divided by the number total number of prices in the set.
The formula for SMA:
SMA = (S1+S2+….+Sn)/n
- S1, S2…, Sn = set of prices
- n= number of period
The exponential moving average gives higher weight on recent prices and reduces lag on the MA. Using three steps one can calculate an EMA.
First, you have to calculate the simple moving average (SMA) for the EMA (previous day) value, because the EMA has to start somewhere, so a simple moving average is being used as the previous period EMA in the first calculation. The second step is to calculate the multiplier. The third step is to calculate the EMA for each day between the previous EMA value and the last day, using the closing price, multiplier, and the previous period’s EMA value.
Exponential Moving Average Formula
EMA = Closing price x multiplier + EMA (previous day) x (1-multiplier)
- Multiplier = (2 / (Time periods + 1) )
- EMA (previous day) = SMA
How To Use Moving Average To Trade In Stock Market
A moving average, while using a candlestick chart helps to cut down the noise. By looking at the direction of the MA helps analysts or traders will get a basic idea of the price movement of a stock. If the moving average line angled towards upside the stock is in an uptrend and if angled downside then it is in a downtrend.
The MA can also act as support or resistance. Suppose in an uptrend, the 50-day or 100-day MA may act as the support level, as shown in the chart above. The red line is 100 days SMA and the green line is the 50 day SMA. The MA acts as a floor and the stock bounces off after touching the moving average. Likewise in a down-trend MA acts as a resistance.
Ideal Period For MA
The ideal period for moving averages depend upon the traders or analysts and their trading strategy and style. The most used period for moving averages is 15 days, 20 days, 50 days, 100 days, and 200 days.
Limitation of Moving Average
Moving averages are calculated on the basis of a security’s historical data and its nature is unpredictable, so the outcome using moving averages can be random. Some time market respects MA some times it does not.
Another problem with MA is that, on a sidewise market trend, its behavior is not predictable and it is hard to find the market’s trend.
A moving average reduces the noise by smoothing the price and creating a new flowing line. This makes predicting the stock’s trend easily. While the EMA react quicker to price changes than the SMA.
Moving average crossovers are a popular trading strategy for analysts to enter a stock or exit one. They use 20 periods, 50 periods, or 100 periods moving averages for better results.
Moving averages are also used to calculate the moving average convergence divergence (MACD) technical tool.
Here is an article on Moving average and exponential smoothing models