In this lesson, we will learn more about another super popular technical analysis indicator, Moving Averages.
Used and loved by many traders worldwide, you can find this indicator included in numerous trading strategies.
Ready to learn more about trading stocks with Moving Averages?
Let’s get to it!
Moving Averages (MA) are a technical indicator used to determine the average price of a stock over a set period of time (which can range from a couple of days to six months – or sometimes even longer).
On the price chart, the moving average is displayed as a line that smoothes out price data.
Because the price action is all smoothed out, many stock traders believe that it is a good indication of the trend direction.
It is considered a lagging indicator and it looks like this.
Moving averages are mega-popular amongst traders of various different financial markets out there.
It is simply because trends don’t move in straight lines, in any market.
Prices zig zag and moving averages are a fantastic tool that helps traders smooth out all these random price movements.
It has the power to clear out market noise and therefore make it easier for traders to identify trends, determine the trend direction and determine support and resistance levels.
I mean, all it takes is one look at the MA slope and you know exactly what the trend direction is! It doesn’t get any better than that.
Now, if you want to calculate an MA, you’ll need a certain amount of data, depending on the length of the moving average you choose.
For instance, a seven-day MA will require seven days of data.
Fourteen-day MA will require fourteen days of data.
Thirty-day MA will require thirty days of data.
And so on. You get the point!
The shorter the length of the MA, the fewer data points are included in the moving average calculation, and therefore the moving average stays closer to the current price.
The longer the length of the MA, the more data points are included in the moving average calculation, which means the less any single price can affect the overall average.
There are two types of moving averages used by stock traders.
Let’s explore both of them in more detail below, shall we?
The first (and most popular) type of moving average we will cover is a simple moving average (SMA).
You calculate it by simply taking a series of prices over your chosen time period, adding these together and then dividing the result by the total number of data points used in the calculation.
For example, let’s calculate the SMA for a seven-day period. All we need is to take the closing prices of the last seven days and divide the result by seven.
Now, let’s say that the last seven data points of the share were: 100, 102, 103, 100, 105, 109 and 105.
The moving average would add these figures together and divide by seven, resulting in an average of 103.4
Pretty straightforward, right?
And do you know what’s even better? Most charting packages will do these calculations for you anyway.
However, there is a reason we bored you with all the maths.
Understanding how an indicator works means you can adjust, tweak it and eventually create different strategies as the market environment changes.
So really, you’re welcome. WINK.
Now, let’s take a look at different examples of Simple Moving Averages and compare how they smooth out the price action on a stock chart.
And to help you visualise it better, we will plot three different SMA’s, a 10-period (short-term), a 20-period (medium-term) and a 50-period (long-term) simple moving averages.
Now, out of the 10-period, 20-period and 50-period moving averages, we can clearly see that the 50 moving average is the slowest while the 10 MA is the fastest.
It is also clear to see that the longer the simple moving average period is, the more it lags behind the price. At the same time, the longer period you use for the simple moving average, the slower it takes to react to the price movement.
Moving on to the second type of moving averages, let’s dig deeper into exponential moving averages (EMA).
Similar to simple moving average (SMA), exponential moving average (EMA) tracks the price of a share over time. The difference between these two, however, is that EMA gives more importance to recent price information and the closing price of the 1st candle will have a very (read: VERY) small effect. As a result, this makes the EMAs much more responsive to price changes of the shares.
A picture speaks a thousand words so let’s take a look at a simple moving average (SMA) and exponential moving average (EMA) side by side on a chart.
See how the blue line appears to be closer to the actual price than the black line?
That’s because it represents the current price action with more accuracy.
And let’s be honest, when you’re trading, you want to know what is happening NOW, not last week or last month.
Truth be told, it’s all about your personal preference.
Both have their own strengths and can be applied in different situations.
And there’s certainly no harm in plotting both on the chart and seeing how they compare.
In fact, why don’t you crack open your trading platform right now and have some fun with the moving averages?
Remember you can experiment with different time periods. And who knows, you might find out which moving averages work best for you!