What is Moving Average and Why is It Important in Trading?
Moving average is the average closing price of a security in a certain frame of time, usually 30, 50, 100 or 200 days. It helps investors know the updated price by filtering out unnecessary data. This technical analysis indicator is referred to as the ‘moving’ average because the value keeps changing with the change in prices of the underlying stocks. Moving averages depend greatly on data on events that have taken place in the past.
Read on to know the types of moving averages, its formula, uses, examples, advantages and limitations.
What is the 30-day Moving Average?
This is an integral part of moving averages. It takes into account the price movements of a particular stock for 30 days and indicates its average price. Investors who have short-term investment plans use this short-term technical indicator widely.
To illustrate this further, suppose that an investor wishes to determine the 30-day moving average of a particular stock. The person would have to add the stock’s closing price for the previous 30 days and divide the value by 30. The result would be the 30-day moving average of the stock.
What Are the Types of Moving Averages?
Detailed below are the different types of moving averages:
1. Simple Moving Average
This moving average lets an individual calculate a stock’s average price over a specific time. The simple moving average, also known as SMA, is referred to as a lagging indicator as it is based on past data on prices. People assess SMA to understand when it would be ideal for entering or exiting a particular stock.
Let us understand this with an example. Suppose a person wishes to calculate a stock’s SMA by considering its closing price for the previous 7 days, which is: Rs. 22, Rs. 22.50, Rs. 22.30, Rs. 23, Rs. 23.10, Rs. 23.50 and Rs. 23.30.
SMA = (Rs. 22 + Rs. 22.50 + Rs. 22.30 + Rs. 23 + Rs. 23.10 + Rs. 23.50 + Rs. 23.30) / 7
SMA = 159.7 / 7
SMA = Rs. 22.81
2. Exponential Moving Average (EMA)
This moving average emphasises recent price movements and tends to be more responsive to current data sets of a financial instrument. Compared to SMA, EMA reacts more quickly to recent price changes in a particular period.
While calculating EMA, a person must first find out the simple moving average of a particular period. Then, one needs to arrive at the multiplier for measuring the EMA indicator. After this, one has to consider the time frame from the initial EMA until the most recent period. Finally, the person will have to use the previous period’s multiplier, price and EMA value. The formula is as follows:
Current EMA = [Closing Price – EMA (Previous Time Period)] x multiplier + EMA (Previous Time Period)
3. Weighted Moving Average (WMA)
This is another type of moving average that lays a lot of emphasis on recent data sets and less on past prices. Traders primarily use weighted moving averages to create trade signals and direction.
For example, if the price of a financial instrument lies above the weighted moving average, it is indicative of an uptrend. However, if the prices are below WMA, it indicates a downward trend. People can calculate the weighted moving average by multiplying each value from the data set by a weighting component.
4. Double Exponential Moving Average (DEMA)
According to economic experts, this is an improved version of the exponential moving average because it focuses more on recent data sets. DEMA is responsible for lowering lag results. It helps short-term traders to spot changes in trends quickly.
DEMA has the closest values among moving averages to the current price points and is thus the most sensitive to price volatility.
5. Triple Exponential Moving Average (TEMA)
The development of TEMA followed DEMA. It is similar to DEMA as it reduces the lag differences between various EMAs. However, the difference lies in the formula. TEMA makes use of a triple-smoothed EMA along with single and double-smoothed EMAs that DEMA uses.
Moving Average Formula
Given below are the details of the formula for calculating the moving average:
Moving average = (C1 + C2 + C3 + C4…Cn) / N
Here,
C1, C2, C3, C4…Cn represents closing numbers, balances or prices.
N represents the number of periods a person wishes to calculate the moving average.
Example of Moving Average
Let us use an example to illustrate the concept of moving average better:
Suppose a stock was trading at Rs.200, Rs.205, Rs.210, Rs.215 and Rs.220 for the previous five days. So, the moving average would be:
Moving average = Rs.(200+205+210+215+220) / 5
Moving average = Rs.210
As we can see, the moving average of the stock for five days is Rs. 210. Now, if we wish to calculate 5-day moving average for the sixth day, we need to exclude Rs. 200 and include the price of the stock on the sixth day, i.e. Rs.225.
Therefore, moving average would be, (205+210+215+220+225) / 5 = 215
Uses of Moving Average
Listed below are various uses of moving averages:
- Moving averages help people understand whether there is any hidden trend.
- Investors and traders widely use them in capital markets to study and assess the prices of stocks with the help of technical analysis.
- Considering that moving averages are primarily based on past prices, people use them as lagged indicators.
- They form the basis for other technical indicators; for example, MACD (moving average convergence divergence) indicator.
Advantages of Using Moving Averages
Given below are the advantages of using moving averages:
- First, the direction of the line of moving average makes one realise which direction a stock’s price is moving.
- Moving average also functions as support and resistance indicators for traders.
- It helps to determine the potential price support.
- A stock’s moving average helps to measure its momentum. Furthermore, it helps to understand the strength and direction of the momentum of an asset’s price.
What Are the Limitations of Using Moving Average?
Listed below are some limitations of moving average:
- Moving averages cannot depict the continuous changes in a stock’s prices and cannot implement predetermined rules across all sectors. This is primarily because every stock has its price history.
- Moving averages are unable to interpret the cyclical patterns stocks often depict.
- This technical analysis tool does not consider the various changes in primary factors that affect the market price of a stock.
- Moreover, moving averages do not consider managerial structure changes in a company or changes in product demand.
- Calculating moving averages will not help identify a trading opportunity if the underlying security fails to trend upwards or downwards.
Final Word
To sum up, the moving average is a technical analysis indicator that traders widely use to understand the trend of price movements of a security. There are various types of moving averages. Significant among them are simple moving average (SMA), weighted moving average (WMA) and exponential moving average (EMA).
FAQs
Ans: If a particular stock is on an upward trend, its moving average functions as the support price or the floor price. However, if a stock is on a downward trend, its moving average acts as a resistance or ceiling level. In this case, note that the price of such a stock will spiral down.
Ans: The underlying concept of this trading strategy is two plotted moving averages will surely cross over at different points. If the short-term moving average crosses the lines of long-term moving average, it is known as a buy signal and stands for a bullish pattern.
However, if the line of short-term moving average crosses below the long-term MA, it is known as a sell signal which indicates a bearish pattern.
Ans: A stock’s average closing price for the previous 200 days is known as the 200-day moving average strategy. It is a popular technical indicator that enables a trader to understand the market trends of a particular security.
Ans: The point when a stock’s price stops falling and bounces back up is known as the support level. It is called so because the moving average functions as a floor from where its prices bounce off.
The level when a stock’s price stops rising is known as the resistance level. Again, this is because a moving average is a ceiling in a downtrend where a stock’s price hits and starts falling again.
Ans: There is no such thing as an ideal moving average. While a simple moving average is very easy to calculate, EMA (exponential moving average) and WMA (weighted moving average) lay more emphasis on recent data.
