What Is a Moving Average and Why Use It?

7 months ago forexsimulation 0

A moving average is one of the tools technical traders utilize in technical analysis. Traders use moving average to evaluate various investments in order to know when to trade and when not to. Moving average operates by evening out price data through the creation of a consistently revised average price.

Moving average usually covers a particular period, which the trader selects. For instance, the period chose could be in days, weeks or minutes, and any other time frame the dealer picks. Using moving average in trade is advantageous in various ways, besides the fact that there are various options of moving averages traders can utilize given the prevailing market conditions. It is also possible for both short term investors plus long term traders to customize the moving average approaches to any preferred duration.     

Types of Moving Averages

Moving average can be classified into two main categories including simple moving average, exponential moving average.

Simple moving average (SMA)

A simple moving average is derived from finding the average of the selected recently sourced price data. what usually happens is that a given time range is picked, the price data during the selected period are summed up. You can then obtain the average by dividing the summed up price data by the total time periods in the chosen range.

Most times, simple moving average’s price data is over a short period of time or a longer period, hence short term SMA and long term SMA. The key variation between these two is in their response to price changes of an underlying security. For instance, short-term averages are quick to respond to price variations unlike the longer term averages.   

For instance, you can sum up a security’s ending prices for a given number of periods, then obtain the average by dividing that sum by the total periods whose data have been included in the sum. That way, you get your simple moving average. You obtain several averages that you can then connect to derive a single flowing line.  

Exponential moving average (EMA)

This type of moving average is a bit complex compared to the simple moving average, because more weighting is applied to the latest data points, hence its other name exponentially weighted. Its reaction is more significant to the latest price variations, than that of the simple moving average, which gives equivalent weighting to every observation over the period calculated. In order to calculate EMA, it would necessitate you to have more observations, than with the SMA.

The exponential moving averages are categorised based on the number of periods used. For instance, there are 12-day and 26-day EMAs, which are considered short term averages. These two, the 12 and 26-day EMAs are utilized in the creation of indicators such as the moving average convergence divergence (MACD) plus the percentage price oscillators (PPO). Generally, the 50-day and 200-day EMAs are utilized to indicate long-term movements.   

Why Consider Using Moving Averages

There are two major reasons for using moving averages.

  • Diminishes the ‘noise’ quantities on the price graphs: all you have to do is just observe the trend the MA is taking to determine the price’s direction. The MA could be angled up or angled down, which represent upward and downward price movements respectively.  
  • Can act a support or resistance: There are the uptrends and downtrends, where the uptrend behaves like the floor providing support, whereas the downtrend behaves as the ceiling causing resistance on the price movements.   

Trading Strategies to Utilize with Moving Averages

There are various trading strategies technical investors using moving average can employ in their day to day trading. For instance, there is the;

  • Crossover MA strategy: It is when prices cross either directly above or underneath a moving average, as an indication of a possible variation in trend.
  • Applying double moving averages to a graph: a longer and a shorter MA are applied, and observed for a given period for the two moving averages to cross each other. The shorter term MA crossing over the longer term MA signifies a buy sign as it is an indication of an upward trend shifting.

On the other hand, the shorter term MA crossing the longer term MA from underneath signifies a sell signal, as it is an indication of a downward shift in the trend.

Limitations of Moving Average

Moving average as a technical analysis tool has some limitations, which act as disadvantages of relying on MA for trade decision making.

One of the limitation is that fact of historical data being utilized in its calculation. Thus, nothing regarding the derivation of MA is projecting in nature. Hence, results from utilizing MA are random.

Additionally, there can be lots of trend reversals resulting from choppy price actions. This may cause a trader to stop and find another indicator to use.    

Conclusion

A moving average is a very important technical analysis tool that enables traders determine what action to take in regards to investments. Through MA, the price movements can be determined to aid in decision making. The two types of MA, the SMA and the EMA both apply to all trades. However, the exponential moving average is mostly reliable since it puts more weight on the latest prices, then the SMA, which puts equal weight on all prices.