3.16 What are moving averages all about?

We all remember counting averages from high school. In mathematics, we get the average of ten numbers by adding the numbers together and dividing the sum by ten. However, in finance and especially in trading, the moving average is a technical indicator used for technical analysis. Analysts and traders calculate moving averages to smooth out price data and be able to better interpret the trend.

Moving averages are simple but key elements of technical analysis. They will help you determine the direction of a trend or support and resistance levels of an asset. Moving averages reflect the previous price movement of an asset. This is helpful in determining the potential direction of changes in the market. In this article, we will help you gain knowledge about moving averages.

Content

• What are moving averages?

• Types of moving averages

• The use of moving averages in technical analysis
   

What are moving averages?

A moving average (or MA) is a technical indicator used by investors and traders to determine the direction of a trend. Any type of moving average is obtained by calculating the average price of previous periods. The word "moving" means that we constantly recalculate it based on the latest price data.

Moving averages are able to illustrate the prevailing market trend with a simple mathematical formula. Properly interpreted, moving averages also signal important moments of the reversal of a given trend. They are also called "lagging indicators" because they require data from  previous prices to generate a trading signal. The moving average is a simple and popular tool used by many traders as a technical analysis indicator.

One of the main advantages of moving averages is their objectivity and ease of interpretation, a unique feature. Each trader or investor can interpret candlestick patterns differently. Similarly, traders set support/resistance levels and trend lines based on their individual preferences and intuitions. In the case of moving averages, the process may look quite different.

Example:
To calculate a 7-day moving average of closing prices, we add up the closing myceny of an asset for the last 7 days and divide it by 7.

Closing prices are the most popular and commonly used types of prices for calculating moving averages. However, it is worth noting that we can just as well use opening prices and sometimes minimum or maximum prices for this purpose.
 

Types of moving averages

In addition to the types of prices used to calculate moving averages, we can also classify the averages themselves. Moving averages vary in terms of how they interpret the results and how they are calculated. Take a look at the four main types of moving averages listed below.

• Simple Moving Average (SMA).

• Exponential Moving Average (EMA)

• Smoothed moving average (SMA)

• Weighted moving average (WMA).

Of the averages listed above, we most often use simple moving averages (SMA) and exponential moving averages (EMA). We will discuss them in detail in the next section.

Simple moving average (SMA)

The simple moving average is an uncomplicated technical indicator, which is obtained by adding the latest data and dividing it by the number of periods (i.e. the number of days or weeks, for example). Since the simple moving average has already been described in the introduction, let us just remind you that it is the arithmetic average of prices collected over a certain number of periods.

Exponential moving average (EMA).

This is a moving average that reflects the price of a specific asset in the market much faster than the SMA. The main feature of this average is that it pays more attention to the latest price points than to older ones. It is therefore more sensitive and better reflects the current market situation.

Moreover, the EMA reacts to changes faster than the SMA. Old EMA values gradually lose relevance, until eventually they become completely irrelevant. Most often, the EMA index is calculated based on the closing prices of assets.

To calculate the EMA, first calculate the multiplier for smoothing (weighting) the EMA. This usually follows the formula: [2 / (number of observations + 1)].

For example, for a 20-day moving average, the multiplier would be [2/(20+1)]=0.0952. Finally, the following formula is used to calculate the current EMA:
EMA = closing price x multiplier + EMA (of the previous day) x (1-multiplier).

An asset is considered to be in an uptrend if the current asset price is above the EMA. Conversely, if the current asset price is below the EMA, then the asset is in a downtrend.
 

The use of moving averages in technical analysis

Moving averages are an extremely useful tool for technical analysis. In addition to determining the current trend, they can indicate the strength of the trend, and also serve as support or resistance in identifying potential buy or sell signals.

The possibilities of using moving averages are illustrated in the chart below. We plot one moving average on the chart, and its interpretation is very simple. If the price is above the moving average line and is pointing upward, there is an upward trend. Similarly, if the price is below the moving average and facing down, there is a downward trend. Take a look at the chart below to better understand the mechanism just described.

So much for moving averages, and their indicative role in technical analysis. In the next lesson, we will learn about the application of the Fibonacci sequence in technical analysis.