This lesson explains the basics of moving averages.
We all heard and dealt with averages in high school. In mathematics, an average of ten numbers is calculated by adding the numbers and dividing the sum by ten. But, in finance and especially in trading, moving average is a technical indicator used in technical analysis. Analysts and traders calculate moving averages to smooth out the price data to interpret the trends in a better way.
Moving averages are simple yet crucial components of technical analysis. They will help you identify the trend direction or support and resistance levels of an asset. Moving averages reflect the previous price movement of an asset which helps you to determine the potential direction of the market. We will help you learn more about moving averages in this article.
This lesson explains the basics of moving averages.
- What are moving averages?
- Types of moving averages
- Usage of moving averages in technical analysis
What are moving averages?
A moving average is a technical indicator used by investors and traders to determine the direction of a trend. Each type of moving average is obtained by calculating the average price from past time periods. The term "moving" means that we continually recalculate it based on the latest price data.
Moving averages are able to show the prevailing market trend using a simple mathematical formula. When properly interpreted, moving averages also signal the moments of a trend reversal. They are also called “lagging indicators” because they depend on previous prices to produce a trading signal. The moving average is a simple and popular tool used by many investors as a technical analysis indicator.
One of their main advantages is the objectivity and ease of interpretation which is also their unique quality. For example, every trader or investor can interpret candlestick patterns differently. Similarly, traders set support/resistance levels and trend lines based on their individual preferences and discretion. However, there is a high chance that this doesn’t happen with moving averages.
To calculate the 7-day moving average of closing prices, the closing prices of a given asset from the last 7 days are added together and divided by 7.
Closing prices are also the most popular and most used types of prices for calculating moving averages. However, it is worth noting that we may as well use the opening prices or the minimum or maximum prices sometimes.
Types of moving averages
In addition to the types of prices used in the calculation of moving averages, we can also distinguish the averages themselves. Moving averages differ in terms of the interpretation of these results and the method of their calculation. There are four main types of moving averages that are listed below.
- Simple Moving Average (SMA)
- Exponential Moving Average (EMA)
- Smoothed Moving Average (SMMA)
- Weighted Moving Average (WMA)
However, the most commonly used moving averages are simple moving averages (SMA) and exponential averages (EMA). We are going to discuss them in detail in the next section.
Simple Moving Average (SMA)
The simple moving average is a straightforward technical indicator that is obtained by adding the recent data and dividing it by the number of time periods (e.g. by the number or days, or weeks). Since the simple moving average has already been described in the introduction, let us just remind you that this is the arithmetic average of prices from a certain number of previous periods.
Exponential Moving Average (EMA)
This is a moving average that will reflect the price of a certain asset on the market much quicker than the SMA. The basic feature of this average is the fact that it attaches more importance to the recent price points than to the older ones. So, it is more sensitive and better reflects the current market condition.
Moreover, EMAs react faster to changes than SMAs. The old EMA values gradually lose their importance until they are no longer relevant at all. Most often, the EMA index is calculated based on the closing prices of the assets.
To calculate EMA, first calculate the multiplier for smoothing (weighting) the EMA. This typically follows the formula: [2 ÷ (number of observations + 1)].
For instance, for a 20-day moving average, the multiplier would be [2/(20+1)]= 0.0952. Finally, the following formula is used to calculate the current EMA:
EMA = Closing price x multiplier + EMA (previous day) x (1-multiplier)
The asset is considered to be in uptrend if the current asset price is above the EMA and if the current asset price is below EMA, then the asset is in downtrend.
Usage of moving averages in technical analysis
Moving Averages are an extremely useful tool for technical analysis. In addition to determining the current trend, they can indicate its strength as well as serve as support or resistance in order to identify potential buy or sell signals on the market.
The possible use of moving averages is presented in the chart below. We plot one moving average on the chart and its interpretation is very simple. If the price is above the moving average line and it is pointing up, there is an uptrend. Similarly, if the price is below the moving average and it is pointing downwards, there is a downward trend. Have a look at the chart below to understand it better.
That is all about moving averages that are used as an indicator in technical analysis. In our next lesson, we will explain the application of Fibonacci sequence in technical analysis.