Moving Averages provide a set of very useful indicators for tracking trends and trend reversals
The Moving Average is one of the simplest, yet most versatile and widely used of all technical indicators. The MA attempts to tone down the fluctuations of market prices to a smoothed trend, so that distortions are reduced to a minimum. MAs help in tracking trends and signalling reversals. You could think of the MA as a curved trendline, fitting itself to the market.
Types of Moving Average
The two most popular types of moving averages are the Simple Moving Average (SMA) and the Exponential Moving Average (EMA).
Simple Moving Average
A simple moving average (SMA) is formed by finding the average price of a security over a set number of periods. Most often, the closing price is used to compute the moving average. For example: a 5-day moving average would be calculated by adding the closing prices for the last 5 days and dividing the total by 5.
For example: a 5-day simple moving average is calculated by adding the closing prices for the last 5 days and dividing the total by 5.
10 + 11 + 12 + 13 + 14 = 60
60/5 = 12
A moving average moves because as the newest period is added, the oldest period is dropped. If the next closing price in the average is 15, then this new period would be added and the oldest day, which is 10, would be dropped. The new 5-day moving average would be calculated as follows:
11 + 12 + 13 + 14 + 15 = 65
65/5 = 13
Over the last 2 days, the moving average moved from 12 to 13. As new days are added, the old days will be subtracted and the moving average will continue to move over time.
Moving averages are lagging indicators and will always be behind the price. Because moving averages are lagging indicators, they fit in the category of trend following. When prices are trending, moving averages work well. However, when prices are not trending, moving averages do not work well.
Exponential Moving Average
In order to reduce the lag in simple moving averages, technicians sometimes use exponential moving averages, or exponentially weighted moving averages.
Exponential moving averages reduce the lag by applying more weight to recent prices relative to older prices. The weighting applied to the most recent price depends on the length of the moving average. The shorter the exponential moving average is, the more weight that will be applied to the most recent price.
For example: a 10-period exponential moving average weighs the most recent price 18.18% and a 20-period exponential moving average weighs the most recent price 9.52%. The method for calculating the exponential moving average is fairly complicated. The important thing to remember is that the exponential moving average puts more weight on recent prices. As such, it will react quicker to recent price changes than a simple moving average.
For those who wish to see an example formula for an exponential moving average, one is provided below.
Exponential Moving Average Calculation
The formula for an exponential moving average is:
X = (K x (C - P)) + P
X = Current EMA
C = Current Price
P = Previous period's EMA*
K = Smoothing constant
(*A SMA is used for first period's calculation)
The smoothing constant applies the appropriate weighting to the most recent price relative to the previous exponential moving average. The formula for the smoothing constant is:
K = 2/(1+N)
N = Number of periods for EMA
For a 10-period EMA, the smoothing constant would be 0.1818.
2/(1 + Time Periods) = 2/(1 + 10) = 0.1818
The EMA formula works by weighting the difference between the current period's price and the previous period's EMA and adding the result to the previous period's EMA. There are two possible outcomes: the weighted difference is either positive or negative.
If the current price (C) is higher than the previous period's EMA (P), the difference will be positive (C - P). The positive difference is weighted by multiplying it by the constant ((C - P) x K) and the answer is added to the previous period's EMA, resulting in a new EMA that is higher ((C - P) x K) + P.
If the current price is lower than the previous period's EMA, the difference will be negative (C - P). The negative difference is weighted by multiplying it by the constant ((C - P) x K) and the final result is added to the previous period's EMA, resulting in a new EMA that is lower ((C - P) x K) + P.
How to Use Moving Averages
Here are just a few simple ideas for putting moving averages to work:
1) Only consider buying a stock if it is above your moving average. By definition, if prices are below the average they are trending down. One of the best pieces of advice I've read on this subject was from Trader Vic. He said
"When picking stocks, I never buy a stock when prices are below the moving average, and I never (short) sell a stock when price is above the moving average. Just pick up any chart book that uses a 35- or 40-week moving average and you'll see why -- the odds of being right are way against you. Mind you, this is after Vic does all of his fundamental analysis on a stock. So even if the stock looks great fundamentally, he'll pass if it's below the moving average."
2) Use moving averages as an exit signal. Seriously consider selling a stock that closes below the moving average.
3) Consider buying stocks as they drop near an upward sloping moving average. You'll notice when looking at charts that stocks often find support (bounce off of) moving averages. Buying on a pullback to a MA will often give you a good risk/reward entry point. You can put a stop-loss order nearby in case you're wrong about the bounce.