A moving average is a calculation that smoothes out fluctuations in price data by creating a constantly updated average price over a certain period of time. The term "moving" refers to the fact that, as new data points become available, the average is recalculated using the most recent data and excluding the oldest data.
Most common moving
averages are used by technical analysis.
1. Simple Moving Average (SMA) :
The SMA is the least complex moving average. This computes the average of a group of data points-typically closing prices-over a length.
Advantages:
- Applied in determining longer term trends as the length
becomes larger, for example, 50-day, 200-day.
Disadvantages:
- It lags the price action since every past data point is
given equal weight.
- May not respond quickly to recent price changes.
2. Exponential Moving Average (EMA):
The Exponential Moving Average (EMA) gives more weight to recent prices, thus it is more responsive to new data. It therefore responds faster than the SMA to price changes and may provide more timely signals.
Advantages:
- More responsive to recent price changes, hence more suitable
for fast-moving markets.
- Helps identify trends sooner than the SMA.
Weak points:
- More tedious to compute.
- May be more susceptible to whipsaws during highly volatile markets (false signals).
How Does Moving Average Work?
(A). Smooths Price Data : During highly volatile markets, moving
averages help filter noise and allow traders to follow price trends rather than
trading over every small fluctuation.
For instance, let's say you're analyzing the closing price of a stock over 10 days. You hardly pay much attention to the variation of the price change from one day to another. Instead, you focus on the average of those ten prices. In a case where the stock is rising, then the moving average will go up with it. But if it is falling, then the moving average goes down too.
(B). Trend Following : Moving averages are following indicators because they are measured using past values and respond to price changes after the event. It makes them trend-following indicators, and most of their application is for validating the trend direction.
- Downtrend: The price is below the moving average, indicating a downtrend.
- Sideways or Neutral
Trend: The price fluctuates around the moving average without directional
movement, usually indicating a consolidation or range-bound market.
Using Moving Averages in Technical Analysis
1. Trend Identification:
They primarily serve the function of checking if the trend is up or down. If a price is above a moving average, then an uptrend is shown; inversely, if a price is below a moving average, a downtrend is represented. The stronger the slope of the moving average, the greater the trend.
- Uptrend: Price continues above an ascending moving average.
- Downtrend: Price continues below a declining moving average.
2. Crossover Strategies:
The most commonly applied moving average strategy is the crossover strategy. This is a sign of a possible change in the market direction when two different moving averages cross one another.
- Golden Cross: This is a bullish signal where a short-term
moving average, for instance 50-day SMA, crosses above a long-term moving
average, for instance 200-day SMA. This may imply that the uptrend may be
beginning.
- Death Cross: This is a bearish signal when the short-term
average crosses below the long-term average, which means there's a high chance
of a downward trend.
Example:
- A seller might look for an entry point when the 50-day EMA
crosses above the 200-day EMA, indicating a buy signal in stocks.
- On the other hand, if the 50-day EMA crosses down the
200-day EMA, it could send a sell signal.
3. Support and Resistance:
Moving averages also act as dynamic support and resistance levels. On an uptrend, it may be a pullback to the moving average-50 days or 200 days-and bounce higher, showing support. On a downtrend, it acts as a resistance point where it is breaking out higher, but still unable to penetrate.
Example:
- A bull market: When the price recedes back to the 50-day moving
average and rallies higher from there, that moving average is a floor in
support.
- A bear market: In this situation, the 50-day moving average may turn into a roof because the price cannot advance much past it.
Moving averages are the most fundamental tools used in technical analysis to identify trends, smooth out price action, and generate trading signals. Moving averages work on averaging historical prices. The SMA is a simple average, EMA reacts more quickly to recent price changes, and WMA offers flexibility in weighting data points. Moving averages are very useful but are lagging indicators and are most.
