What is a moving average and how can it help me with my technical analysis?
What are moving averages?
A moving average is one of the most popular indicators used by traders and investors in technical analysis. It is a combination of price points that have been averaged out to form a trend, effectively smoothing out the outliers from price fluctuations to present a picture of the price movement of an asset over time. It should be noted that a moving average is an average that follows a trend. It is possible for a moving average to be a lagging indicator too.
In their most basic forms, moving averages come in two distinct varieties: the exponential moving average (EMA) and the simple moving average (SMA). An exponential moving average assigns greater weight to recent price movements. The simple moving average is basically the average of a security over a predetermined period of time. Moving averages are essentially used to anticipate trend direction in price movements. They are also useful tools in technical analysis for the purposes of plotting resistance levels and support levels.
How do moving averages work?
Every tradable asset has multiple prices over any given period of time. As these price points are plotted on a graph, they can form trends and patterns. Moving averages smooth price data so that the trader can follow the price trend on a graph. It should be noted that at no time does a moving average anticipate price direction. It is best described as a definition of the current price direction with the effect of a time lag factored in.
The reason there is a lag with moving averages is that these graphs are based on past data. Since they smooth out price data over time, they are ideally suited to technical analysis. And they work well with tools like overlays. Indicators such as the MACD (Moving Average Convergence Divergence) and the McClellan Oscillator are predicated on moving averages.
Exponential moving averages
With an exponential moving average, the importance of past prices is more heavily weighted in favour of the most recent prices. The weighting ratio is dependent on the number of time periods in the MA. The three-step process to calculating exponential moving averages is as follows:
- Work out the simple moving average
- Work out the weighting multiplier
- Work out the exponential moving average
Simple moving averages
With a simple moving average, you are essentially calculating the average price of a tradable asset over a preset time period. Moving averages are calculated from closing prices. In the case of a 10-day simple moving average, you would calculate the sum of the last 10 days of closing prices and divide it by 10. Since this is a moving average, the average moves every day new price data is added. When that happens, the least recent data is dropped to accommodate the new data.
Moving averages also have what is known as the lag factor. Since data is measured over time with moving averages, the lag factor always comes into play. As the duration of a moving average increases, so too does the lag effect. 10-day MAs tend to change soon after prices turn. By contrast shorter MAs are highly responsive to change. These moving averages can be likened to speed boats on the short end and ocean tankers over the long term. As they get longer they are slower and less responsive to change, thereby being less likely to mirror recent prices.
Are moving averages good for technical analysis?
Yes they are. The reasoning behind using moving averages as part of technical analysis is simple: by giving a clear picture of the trend, they can be combined with current price data to flag up significant price changes.
For instance, when the price of a security moves above its moving average price, this can be viewed as a signal to buy that security. And when the price of a security moves below the moving average price, this can be viewed as a signal to sell that security. Moving averages do not determine the floors and ceilings of securities, but they are indicators of performance over time.
By following the price movements listed in a moving average, you can purchase soon after the price of that security has bottomed out. Or alternatively, you can sell that security soon after it tops out. That is how traders use moving averages as part of their technical analysis. There are generally accepted timeframes for moving averages. They are defined as follows:
- Extremely short term: 5 to 13 days
- The short term: 14 – 25 days
- Minor intermediate term: 26 – 49 days
- The intermediate term: 50 – 100 days
- The long term: 100 – 200 days
Moving averages are not static indicators. They are always changing and this is what makes them valuable resources for technical analysis. Since these MAs give a clear indication of price movement, upwards direction shows upwards price movement and downwards direction shows downwards price movement. By viewing longer-term MAs, you can easily see ceilings and floors which will assist greatly with your technical analysis.
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