What are moving averages?
- Moving averages are one of the most useful methods of identifying and profiting from trends by the smoothing of price data
- Moving averages are one of the oldest tools in technical analysis and are used in many different types of capital markets such as stock, commodity and foreign exchange markets
- Moving averages are a lagging indicator
Why do we use moving averages?
- Moving averages are used to smooth price (the longer the period, the smoother the moving average will appear)
- Moving averages help technicians determine trend and trend changes
- Moving averages are used to identify support and resistance levels
- Moving averages can also be used to identify increasing or decreasing price momentum
- Moving averages have become a very important tool due to the recent shift toward algorithmic trading
The two most common types of moving averages
Simple moving average (SMA)
- Constructed by adding a set of data (closing prices) and then dividing by the number of observation in the period being examined
Calculation:
- Daily price close of a stock between March 10th and March 19th: 1,2,3,4,5,6,7,8,9,10,
- First data point of a 10-day simple moving average is calculated as follows: (1 + 2 + 3 + 4 + 5+ 6 + 7 + 8 + 9+ 10) / 10 = 5.5
Exponential Moving Average (EMA)
- Gives a higher weighting to recent prices unlike the simple moving average which gives each price equal weight, thus reduces lag time
Calculation:
- Simple moving average calculated above = 10-period sum / 10
- Current Weight: (2 / (# of days in the moving average + 1) ) = (2 / (10 + 1) ) = 0.1818 (18.18%)
- EMA = ((Current price – Previous EMA) × Current Weight) + Previous EMA
For a more in depth look at how to calculate moving averages please read more (CLICK HERE)
Commonly used moving averages
50-Day Moving Average
- The average closing price of a stock over the last 50 days
- Has been called the Swiss army knife of investing tools
- Used for determining the short to medium trend
- Often acts as the first major area of support in an uptrend or the first major area resistance in a downtrend
- Price generally remains above the 50-day moving average in a persistent uptrend as institutional investors favor buying at that level on price weakness
- The 50-day moving average appears as the 10-week moving average on weekly charts
200-Day Moving Average
- The average closing price of a stock over the last 200 days
- Used for determining the overall trend
- If a stock is above an upward sloping 200-day moving average, the stock is considered to be in an uptrend
- If a stock is below the 200-day moving average, the stock is considered to be in a downtrend
- Recognized as a major support when price is above this moving average and resistance when price is below
- The 200-day moving average appears as the 40-week moving average on weekly charts
There is a self-fulfilling prophecy aspect to the 50 and 200-day moving average. Markets tend to react strongly in relation to each because they works so well. The reason they work so well is because a majority of market participants watch and react when these levels are met.
Strategies for using moving averages
- Determining whether a stock is in an uptrend or downtrend
- Determining support or resistance
- Can be used as a trailing stop-loss order
- Used in the construction of many commonly used technical indicators such as the MACD and Bollinger Bands (to name only two of many)
- Giving Buy or Sell Signals (many technicians use the moving average cross as way to determine buy/sell signals)
The Golden & Death Crosses
- The golden cross is a bullish technical indicator formed when the 50-day moving average crosses above the 200-day moving average suggesting a new uptrend has begun
- The death cross is a bearish technical indicator formed when the 50-day moving average crosses below the 200-day moving average suggesting a new downtrend has begun
Final Thought
Moving averages are a very important tool and can be customized to each investors personal trading system, time-frame and strategy. When used properly it can be a very profitable endeavor.
Have a great day! 🙂
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