The moving average (MA) is a technical analysis tool that analysts and traders use to determine the price direction of a trend. It takes into consideration the average of data points by dividing the data points for a specific period of time by the total data points. The MA is calculated constantly in order to include the latest data points.
Note: By data points, we mean the prices of a security.
Moreover, the MA is referred to as the lagging indicator because it marks the price movement of an underlying asset to produce a signal or show the direction of a given trend.
Analysts and traders are widely using moving averages to determine support and resistance levels in which the price of an asset moves. The reason is important to traders is that it can identify the potential direction that the price will move.
A very common question that people ask is whether the MA can be used to forecast or not. So the answer regarding forecasting the potential direction of an asset is yes. As mentioned above, this is why the MA is widely used by traders since it helps them take positions and identify trading signals.
This is the most straightforward of the moving averages and is taking into account the recent data of price and divides them by the total data prices of an asset to find the average. Traders use it to identify potential entries or exits in the market. An SMA is a back looking tool and can be applied to past prices for a given period of time.
The SMA helps to identify resistance and support levels or buy or sell signals in the market.
The formula for calculating the SMA has as follows:
SMA= (A1 + A2 + A3 + …. An) / n
A is the average in period n
n is the number of periods
Assume you are a trader and you want to calculate the SMA of a stock by looking at the closing prices for the last 5 days. The closing prices were: $23, $24, $25, $23.50, $23.20.
SMA = (23 + 24 + 25 +23.50 +23.20) / 5 = $23.74
The EMA takes into consideration the same data with more weight to the most relevant prices which are the recent prices. EMA tends to be more responsive to recent price data than the SMA which applies equal weight in the data prices.
There are 3 steps for calculating the EMA:
Multiplier = [2/ (Selected Time Period + 1)]
For example, if the time period given is 14 the equation will have as follows:
2/ (14+1) = 0.13333
The last step is to calculate the current EMA.
This is the last step and calculates the current EMA by taking the period from the initial EMA until the most recent time period. It is using the price, the multiplier, and the previous period’s EMA. It is computing with the following formula:
Current EMA = [Closing Price – EMA (Previous Time Period)] x Multiplier + EMA (Previous Time Period)
The question is always which MA to use when trading. One of the differences, as has been said, is that the EMA gives weight to recent prices. The EMA is moving faster than the SMA, it will change direction faster, following the trend of recent prices. On the other hand, the SMA will need more time to recognize the changing trend.
However, this means that the EMA will be more outspoken in giving the wrong signals that may occur. It will show them too early, and the possibility of error occurs much faster. Thus, while the EMA immediately follows the reversal of the trend, the SMA moves more slowly. It means that the SMA lasts longer in the game, and this is significant, especially when there is a short-term unpredictable price movement.
In summary, EMA will react on time to trend changes but also a greater possibility of errors. SMA shows the changes much slower but less inaccurate signals during instability.
If you want to be part of the trading daily lifestyle, then sure you will find MA useful. If you want to identify signals and reactions fast then SMA is your friend. The periods that should be used are:
9/0 period (Don’t use it for less than 15 mins)
Best used as an indication of a trend reversal when crosses longer time period MA.
21 period
When combined with RSI it can give a strong overbought or oversold signal.
51 period
The further it is from the candles the stronger the trend will be.
200 period
1.Widely used
2.Shows the annual price changes
3.Not for stock flips or short term trading
4.Mostly used for indices such as S&P
Overall the shorter the time frame used the more sensitive the average will be to price changes. The longer the time frame used to identify the average, the less sensitive will be to price changes.
The first one is called the ‘’crossover’’ and is one of the main MA strategies. The first type is the price crossover. This is when a price crosses above or below a MA to indicate a potential change signal in the price trend.
The second one is called the ‘’golden cross’’. It is identified when you use two moving averages to the chart. For example, one longer and one shorter. When the shorter MA crosses ABOVE the longer MA it indicates a buy signal.
The third one is called the ‘’death cross’’. Again when you use two MAs on the same chart one longer and one shorter. When the shorter MA crosses BELOW the longer MA it indicates a sell signal.
To sum up, a MA helps to clear out the data of stock price changes and puts them in one clear line. This makes the traders or analysts read the trend easier and faster. EMA reacts faster than SMA which in some cases can be confusing since it can indicate false signals.
The MA is widely used and can be even more effective when used along with other indicators.
In order to use the MA, you will need an investment account. We at FDGT have put our recommended brokers which can be a great start for you to practice even on a demo account.
