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Understanding Moving Averages: A Key Tool for Smarter Trading

What is a Moving Average?

All the traders and investors who flourish in the financial markets usually conduct thorough research and the use of relevant tools before each transaction. They gain from methods such as technical analysis and diverse markers that assist in understanding the trends and changes in the market. One important marker that most market people like using is the Moving Average. Whether you are a pro in trading or just starting your investments in stock terms, understanding what moving averages are and how they work in trading can make sound decision-making for you.

Moving Averages as an Introduction

Moving averages are the most popular analysis of technical indicators in the stock market, which smoothens price data and reveals the trend in it over the short, medium, or long term. Depending on the type of analysis and the need, moving averages can be calculated in an average of days-from as low as 20, 50, 100, or 200 days, etc.

The three main types of moving averages are Simple Moving Average (SMA), Exponential Moving Average (EMA), and Weighted Moving Average (WMA). You will learn about these types in this blog in detail.

For example, suppose you want to compute the moving average of the closing price of a stock over a 5-day period using a dataset of 10 days closing prices. You used measure price averages by spending the first five days-measured up from the Day 1 to Day 5. How does that become moving? You would measure the next five days of its prices-from Day 2 to Day 6. And so on and so forth:

So, you notice that the exact five days for which you are considering calculating the moving average are moving indeed: from Day 1 to Day 5 is one five-day period; from Day 2 to Day 6 is the next five-day period; from Day 3 to Day 7 is the next five-day period; and so on and so forth.

Types of Moving Averages

Moving averages appear in several variations, every using its own unique calculation and interpretation method. Here, we introduce you to the three main types:

Simple Moving Average (SMA):

The Simple Moving Average is the simplest of all this tool. It calculates an average of the given number of data along a specific period. For example, to get a 10-day SMA, you simply add the closing prices over the last 10 days and then divide by 10. It smooths up the price curves of a stock chart to help identify trends.

This below shows the simple moving average formula:

Simple Moving Average = A1 + A2 + A3 + A4 + …… + An/n

We shall clarify this with an example: suppose a trader wants to calculate its SMA for the last five days for the stock X. The closing prices of X on those last five days are assumed to be: ₹100; ₹105; ₹103; ₹107; and ₹105.

The trader will have to add these prices, so he totals up the amount to ₹520, and then, he needs to divide this by how many observations he makes, which is 5.

Simple Moving Average = 520/5 = ₹104

Exponential Moving Average (EMA):

Such type of average is used for providing more weightage to the recent prices over the simple moving average. Therefore, it is more dynamic to the recent changes in the market compared to the easy moving average. The weightage applying to the current price and that of the previous price for the EMA will decrease exponentially. It uses a much more complex formula having more weightage to the recent data points.

Current Exponential Moving Average= (Closing Price * Multiplier) + [EMA (from the previous day) X (1-multiplier)].

Weighted Moving Average (WMA):

The Weighted Moving Average (WMA) places a considerable weight on the recent prices making it very sensitive toward the changing market scenarios. You may be wondering how it differs from an EMA. After all, in EMA also, more weightage is given to the recent prices than to the older prices. The only difference is that in WMA, the reduction in weightage of prices is linear along with time; whereas, in the case of EMA, this is done in an exponential fashion with time. WMA can be calculated as given below:

WMA = [Price1 x n + Price2 x (n – 1) +……… Price] / [{n X (n+1)}/2]

Simple Moving Average vs Exponential Moving Average

Moving Averages Method In Trading: Their Importance

Now, why should one employ moving averages in trading? The simple answer is that these indicators render clarity with chaos. If one views a chart representing the daily price of a particular stock, one would see it jumping up and down and very difficult to weigh it.

Even really busy traders find it difficult to understand the trend by looking at the daily chart price movement of a stock. Well, this is where the moving average method comes handy. Moving average dampens the noise in daily prices that helps in establishing the true direction.

So if there appears to be a crossover of a short-term moving average over the longer-term moving average, it signals that the price is bound to move upwards and gives you the opportunity to buy. Generally, when such a short-term moving average goes below the longer-term moving average, it indicates prices tend to move downward in the future. Therefore, one would follow this for going short on a stock.

Apart from that, you also have many types of moving averages: SMA, EMA, and WMA. If you believe, for instance, that stock prices have exhibited much higher variability now than before, and you want to give recent periods more weight, you would prefer EMA or WMA instead of SMA. So, now that we’ve understood the importance of moving average method, let’s check out what are the merits and demerits.

Moving Averages to Equip You for Stock Purchase

Having understood the above, let’s now look at how trading is done using moving averages:

Identification of Trends: The primary purposes are defining the trends. Whenever stock price movement is found above or below its moving average, it may refer to an upward trend. This may be an indication of buying.

Crossovers: Another of the necessaries method is to check for crossovers of the two moving averages. Whenever a moving average averaged a shorter time span crosses that of a longer one, it denotes possible rise. If, however the shorter moving average comes down crossed lower than the longer, it indicates that the opposite trend is likely upcoming.

Support and Resistance: Moving Averages can also act like changing points of support and resistance. So we can see in a stock price that if the moving average is really reached from below, it bounces then it’s considered some kind of support. On the flip side, if a company stock cannot cross the moving average from a higher point, then it can be considered a resistance level.

Confirmation: Moving averages by themselves are very powerful tools, but work best with other indicators or methods. By bringing them together with other measures, possible trends are more clearly confirmed and potential false signals reduced.

Conclusion

It is in the up and down world of trading where the moving average becomes a beacon. The moving average provides solace from the volatilities of price movement in stocks and helps one focus on larger trends. Different moving averages, from the very simple and soothing SMA to an ultra-sensitive EMA, all stand you in the way of some real artillery for finding trends, timing decisions and even confirming prospective opportunities.