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How does the Moving Average work?
Let’s be honest, many traders in the early steps of their trading career feel somewhat the same. Lost.
As a beginner, the “compass” that will lead you out of this storm, is a tool called the Moving Average.
In our previous article, we talked about how the moving average is a curving line, and when the current price is above the moving average, then you may assume that the market is moving upwards.
Similarly, when the price is below the moving average, then we can assume that the market is moving downwards.
Additionally, the moving average line is formed by dots, and each of these dots represents an average of prices.
Now let’s have a look at how the moving average is calculated!
For example, take the following 5 prices on the price chart: 10, 20, 30, 40, and 50, and add them up to get 150.
To calculate the average, we divide by 5 since we have 5 numbers, and we get 30.
Now, a 3-period moving average will consist of many dots, each corresponding to the average of the corresponding 3 prices.
Say, we have 6 prices: 10, 20, 30, 40, 50, and 60. 10 is the oldest price and 60 is the most current price.
Now group these prices in groups of 3, starting with the 3 oldest prices.
So, 10, 20 and 30 is the first group.
If you add them up to get a total of 60 and then divide by 3, the first dot is 20. Then, we leave out the price of 10 and we add 20, 30 and 40.
The total then is 90. Again, divide by 3 to get 30. This is the second dot.
Now, to calculate the next average or dot we leave out price 20 and add 30, 40, and 50 to get the total of 120. After dividing by 3 we get 40.
We do the same for the last 3 prices, 40, 50 and 60, and the total is 150.
Then we divide by 3 to get 50.
Now, if you connect the dots, you can see the Moving Average line!
Awesome!
