What Is a Moving Average: Meaning, Definitions, How To Calculate It
Moving average (MA) is a popular and efficient technical tool used by most traders in the modern financial world. It is based on data points during a specific period in the past and aims to give a more precise picture of an asset’s trend. The reason why the indicator is characterized as “moving” is explained by the constant recalculation of the value with new data entries. There are different types of MA such as Simple, Exponential, Weighted, etc.
Analysts use this indicator to estimate the support and resistance of a security’s price. In this article, we will analyze and give some examples of moving averages, explain when to use them, which are the limitations, how to calculate them, etc.
Understanding a Moving Average (MA)
Moving average (MA) is a technical analysis indicator that provides traders with important information on whether it is the best time to buy or sell their assets. MA is calculated by summing up several data points within a specific period and dividing them by their total number. As a result, analysts can take advantage of a single trend line to monitor the levels of support and resistance.
Μoving average definition suggests that it is a lagging indicator. The wider is the time frame the higher degree of lag may occur. Thus, a 100-period MA will use more points than a 10-period MA and as a result, the lag will be greater. Of course, it is up to investors which time frame they will use to calculate the moving average.
Traders usually pick smaller periods so that they could have an efficient result that will be more responsive to sudden price changes. To calculate the moving average most analysts choose periods of 15, 20, 30, and 100 days. The 50 and 200 day MA calculations are popular among investors because they provide more accurate trading signals.
The calculation of MA lays a sound foundation of various technical indicators such as MACD, Bollinger Bands, and the McClellan Oscillator. One of the most popular moving average types is the simple moving average and exponential moving average. Those two are placed over or under the price line and serve to indicate both the momentum and the trends.
Types of Moving Averages
Here are some types of the moving average that can be implemented in trading:
Simple Moving Average (SMA)
SMA is the simplest type of MA and the most fundamental amongst others. It is an arithmetical calculation based on the sum of the past data points of a certain period (A1+A2+…+An) and divided by their number (n). For example, if someone wants to count the SMA of a previous 20-day period, they just need to sum the values of the chosen time frame and divide it by 20.
The simple moving average is based on the recalculation of each day’s value with the new data entries. The last value of the chosen data points is replaced with the latest one, so the result every day changes. This is why the Average is called “moving”. Below there is the formula an investor needs to apply to count the SMA.
Exponential Moving Average (EMA)
Another type of MA is the exponential moving average which is commonly used by traders as a more responsive value of MA. EMA is sensitive to price changes as well as the entry of new information. It gives more importance to recent prices and makes use of the SMA of a specific day as its first data entry.
Since it is based on a particular period of MA, EMA is calculated with the following steps:
- The value of SMA should be calculated with the formula that is given above.
- As a next step, the multiplier for weighting EMA needs to be calculated by the following equation : [2/(selected period + 1)]. This is also known as the “smoothing factor”.
- The final result is received by the combination of the weighting multiplier with the previous EMA.
Here is the formula to calculate the EMA:
- In the equation above the EMAt is today’s EMA
- Where Vt is today’s Value
- EMAy is the Yesterday’s EMA
- s = Smoothing
- d = Number of days
Weighted Moving Average
The Weighted moving average is another type of MA which is similar to EMA. It is based on the most recent values of a specific time frame and is not based on the oldest ones. What makes it different from the exponential moving average is that it grants a weighting in each latest value.
The value of the Weighted moving average comes from the multiplication of each data point with a specific weight value that has been determined before the final result. It is considered to be a more accurate index than SMA and is used by analysts to define the asset cost bases in various periods.
Simple Moving Average (SMA) vs. Exponential Moving Average (EMA)
Both SMA and EMA are based on previous data points of a chosen time frame. However, the main difference between them is that the latter uses the most recent data points of a specific past period and adds weighting to them. This is why the EMA is defined as a weighted average calculation.
Additionally, the EMA has less lag and a higher sensitivity to recent price changes. SMA defines a more complete and precise picture of the true average prices for a whole period. Thus, it is considered to be more suitable for identifying the levels of support and resistance.
Most traders consider the EMA to be a more accurate indicator since it is sensitive to quick price changes. Moreover, the formula that is used to define the EMA is thought to be way more complicated than the SMA. However, EMA’s responsiveness to changes made most investors choose it as a more accurate and effective trend indicator.
Example of a Moving Average
The moving average is an indicator that can be defined through the SMA or the EMA. Either way, investors need to choose which average they will use since they are calculated with different equations. For example, a trader may choose to use the SMA of an asset in a defined 20 period :
- Week 1 (5 days) : 20, 21 , 29, 25, 19
- Week 2 (5 days) : 26, 22, 20, 27, 28
- Week 3 (5 days) : 29, 30, 33, 29, 33
- Week 4 (5 days) : 35, 29, 27, 30, 31
Given the values above, a 5-day moving average can be calculated by adding the latest data points of the last week. So the latest entry is the value 31 of the 4th week and the first SMA point of the line would be: (35+ 29+ 27+ 30+ 31)/5. The result will be 30,4. To define the next point of the SMA line you just need to repeat the same calculations but this time the first price will be the value of 30 from the 4th week. So the result will be formed by the following: (30+ 27+ 29+ 35+ 33)/5 = 30,8. If you continue with all the given data points in a set of 5 with this formula until there are no total 5 entries to take, the simple moving average is formed.
Example of a Moving Average Indicator
The moving average indicator can be used in combination with the Bollinger Band indicator. In a graph, the latter has two bands, the upper band, and the lower band. The MA is a line in the center between these two bands. Each of them has a distance of two standard deviations from the moving average.
Analysts monitor the behavior of an asset and can understand that it is becoming overbought when its price comes closer to the upper Bollinger band. Conversely, when the price line moves close to the lower band the asset is likely to be oversold.
What Does a Moving Average Indicate?
A moving average is a technical tool that indicates the average value of an asset’s price within a specific period. From simple average tools to more complex formulas that can only be calculated with sophisticated methods, MA keeps tracking the average changes of a stock’s data series over time.
Most analysts also use the MA indicator to monitor price characteristics such as volatility, momentum, etc. A downward trend signifies a decline in securities price while an upward trend in MA indicates a rise in the price of an asset.
What Are Moving Averages Used for?
Moving averages are popular technical analysis tools that help traders to detect potential changes in an asset price. Investors can use MA to foresee possible rough changes in the price momentum as well as to define and profit from potential buy or sell signals. Thus, MA is considered to be an efficient indicator of bullish or bearish behavior of a security’s value.
What Are the Most Common Days Used in the Moving Average?
Traders can choose either a shorter-term or a longer-term moving average model. This depends on their investment strategy and style. When the time frame consists of a 10 or 20 day period, the MA is considered to be more sensitive to price changes. Some investors choose a longer period (100 to 200 days) that helps them locate and confirm potential buying or selling signals. Generally, the MA can be based on 10, 20, 30, 40, or 100 days periods, with the most popular to be the 50 and 200.
What Are the Limitations of a Moving Average?
The moving average can be an efficient indicator for many investors. However, just like any other technical tool, it has some drawbacks. Since MA is a lagging indicator that is based on a stale or old data point, it needs to keep a continuous record of different periods for any predicted period.
Moreover, sudden fluctuations in the price make it difficult to implement MA in a short-term strategy. This indicator may produce some false signals since it may ignore or miss some more complex data points.
What Is the Moving Average Convergence/Divergence?
Most traders attempt to foresee the direction of an asset’s price with the help of the moving average indicator. This way they can estimate potential buy and sell signals of an asset. Through the calculation of MA, other technical indicators can arise such as the moving average Convergence/Divergence (MACD).
To monitor the interaction between two different MAs particular periods are used to calculate the MACD. These time frames are 9, 12, and 26 days in the EMA through which the price’s trend and momentum can be estimated. MACD’s result comes from the subtraction of a 26 from a 12-day exponential moving average.
After calculating the value of MACD, analysts can specify the direction of the market. In the situation of crossover if the MACD is above the signal line it is a sign of upward momentum. Conversely, if the MACD is below the signal line it indicates downward momentum. Moreover, it’s crucial to pay attention to the position of MACD according to the zero line. To determine if there is a potential buy or sell signal traders need to analyze if the line is above or below zero respectively.
Moving Average Calculation and Graphing Example
For the calculation of MA and the creation of the graph, traders choose a specific number of days in a time frame. For example, if an investor needs to calculate a 50-day moving average he just needs to sum the closing prices of the last 50 days of the asset and then diverse the result by the number of periods, which in this case is the value of 50.
This way analysts create a specific point on the MA graph. To continue with the next day’s result, the oldest number of the period is being replaced by the most recent closing price and the same equation is being solved. In the end, the MA line is being drawn. The same calculations are being done regardless of how long or short the chosen MA period is.
When all the calculations are done the results are placed on a graph as is demonstrated below:
Moving averages are types of technical analysis indicators. Not only do they help investors to identify the current price trend but also possible price reversals, bullish and bearish signals, the levels of support and resistance. Since there is a variety of them, every trader has to choose the one complying best with his trading strategy and style. Note, that like any other technical tool, MA comes with its limitations, thus it’s reasonable to combine it with other indicators to increase the efficiency of your trading decisions.