Enhance Your Trading Game with THESE Calculations
Technical indicators are used by traders to understand momentum in stock price movements.
There are dozens of different indicators. Different traders favor specific indicators depending on their strategy.
One of the most common and widely used technical indicators is the moving average.
It’s crucial to understand that there are several types of moving averages. Each looks a little different on a chart and has varying significance when it comes to trading setups.
I know traders who love technical indicators and pay attention to several. Others choose only a few.
Understanding moving averages is essential. There are several trade setups where a buy or sell signal is triggered, supported, or confirmed by this great technical indicator. The moving average is also the basis for several other technical indicators.
Let’s get started…
What Is Moving Average (MA)?
If you’re new to trading, looking at a chart can be a little overwhelming. But there are tools you can use to make sense of what you see …
Moving average is one stock market indicator that can help you cut through the noise of big price fluctuations.
If you look at a chart for a stock with high volatility (the kind I love to trade) you see big price swings and jumps. The chart looks ‘jagged.’ The moving average smoothed price movements into a curved line.
Because it is based on past price points — or data points — it’s considered a lagging indicator. The longer the period, the more the moving average lags. For example, a 200-day moving average lags more than a 50-day moving average.
So what is a moving average?
In its simplest form, a moving average takes the closing prices of a stock for a certain period (usually calculated in days) and averages the price. The average price is plotted as a line on the chart.
Common periods for moving average are 10-day, 20-day, 50-day, and 200-day. However, with modern charting software, you can set the number of days as well as intraday periods for calculation.
For example, I know a swing trader who uses a 9-day moving average based on the daily close. He compares it to another technical indicator — the volume weighted average price (VWAP) — to determine if a trade meets his criteria.
Traders are usually more concerned with short-term moving averages — say 10-day or 20-day — because there’s less lag. However, crossover of a short-term moving average in relation to a longer-term moving average is a common trading signal. More on that later in this issue.
Types of Moving Average (MA)
There are different types of moving average. The three most common are:
- Simple moving average (SMA)
- Exponential moving average (EMA)
- Weighted moving average (WMA)
I’ll give a brief explanation of all three, then we’ll focus on the two most used by traders: the SMA and the EMA.
Simple Moving Average (SMA)
The simple moving average is the most common type of moving average. It takes a sum of past closing prices over a given period and then divides by the number of price or data points.
A 10-day SMA takes the last 10 closing prices, adds them together, and then divides by 10.
Exponential Moving Average (EMA)
An exponential moving average gives more weight to the most recent data points or prices. This is done by adding a weighted multiplier to the equation. It is slightly more complicated but keeps the moving average line closer to the price changes you see on a chart.
A good way to think of it is this: The EMA reacts to price changes quicker than the SMA.
The primary difference between EMA and SMA is the EMA has less lag time. On a chart, the EMA plot line adjusts faster in relation to recent price fluctuations. This is because of the weighted multiplier.
Weighted Moving Average (WMA)
Like the exponential moving average, the weighted moving average assigns more weight to recent data points. However, in a weighted moving average, distribution of weighting is equal. In an exponential moving average, the weighting is exponential.
Rolling average is another name for a moving average; it’s sometimes referred to as a rolling average in statistics.
Trailing average is another name for moving average. Moving average, rolling average, and trailing average mean the same thing — but different industries prefer one term over the other. Some MS Excel experts prefer the term trailing average.
For our purpose — to gain knowledge and learn to trade — I’ll stick with moving average.
How to Calculate Moving Average and Use It While Trading
With all modern charting and trading software, you can pull up technical indicators as overlays on the chart. So I want to show you how to calculate it yourself.
Even if you never do it this way again, it helps to understand what’s happening when you input data in the charting software. Yes, stock market analysis is largely automated now, but that doesn’t mean you should ignore how it works.
Moving Average Common Formulas
Ready to give it a go? Here’s how you calculate simple and exponential moving averages …
Simple Moving Average Formula
Take the closing prices for the number of days you want (known as the period), add them together, and divide by the number of days.
For example, a 10-day SMA adds the last 10 closing prices and then divides them by 10. It looks like this: [(Day 1 + Day 2 + … Day 9 + Day 10)/10] = SMA.
Let’s do it with real numbers. We’ll do a 10-day moving average. To keep it simple, we’ll use whole numbers for the closing stock price. Here’s the sequence of closing prices: 9, 7, 4, 6, 7, 8, 10, 11, 9, 11.
Now add them together, then divide by 10:
[(9 + 7 + 4 + 6 + 7 + 8 + 10 + 11 + 9 + 11)/10] = 82/10 = 8.20. Voilà, the simple moving average is 8.20.
Once the next closing price is known, drop the first number from the sequence and make the new closing price the last number.
Let’s say the next closing price is 10. In the equation, the first data point is now 7. We dropped the data/price point from 11 days ago and added the latest price. Now the sequence adds up to 83. Divide by 10 and you get 8.30. On and on it goes. Each new SMA gets plotted on the chart.
Exponential Moving Average Formula
The exponential moving average is a bit more complicated. You got this, right?
Here’s what the equation looks like: [Current day close – previous EMA] * [2/(n+1)] + previous EMA.
Before you do the calculation, let me explain a couple of things. Current day close is the last number in your set. Let’s take the second set: current day close is 10.
Previous EMA — we don’t know yet. In real-world EMA calculations, the more data points, the more accurate the output. But we have to start somewhere so I’m going to use the 10-day SMA from the example above. So we’ll go with 8.20 (previous day SMA).
Then in the equation is the period or number of days. In this case, 10.
Again, we’ll use SMA to calculate the first one. Remember your order of operations from math class?
Here it is: (10 – 8.2) * (2/11) + 8.20 = 1.8 * .18 + 8.2 = 8.52. ⇐ this is your EMA.
Notice the EMA is a little closer to the closing price than the SMA. In our example above, the SMA for this day (closing price 10) was 8.30. The EMA is 8.52. Each day you’d do the same thing. Input yesterday’s close and previous EMA, then balance the equation.
… And so on, and so forth…
How would you like to have to do that every time you wanted to plot the EMA? I sure wouldn’t. That’s why I let my trading software do all the work for me. In my opinion, you should do the same.
Check it out…
Any modern charting software or tool lets you calculate moving averages, both simple and exponential. You put in the time period and — boom — plot line appears on the chart. You gotta love it.
You can even have multiple moving averages on the chart and choose which color represents each period. Then you can use it for trading instead of spending hours with a calculator or a spreadsheet.
Support and Resistance Analysis
Many traders use moving averages as part of their technical analysis of stocks. The moving average can be helpful in determining support and resistance levels.
To make it simple, take a look at the DJIA (Dow Jones Industrial Average) for any one-year period. The DJIA is a stock index, which tracks a group of stocks together. There are several different indices, but those most often mentioned on channels like CNBC are the DJIA, the Nasdaq, and the S&P 500.
You might be wondering how these moving averages provide support and resistance. After all, the stock price is determined by supply vs. demand, right?
The reality is, traders and market makers play a psychological game of cat and mouse. One of the things they might look for is stock prices.
Depending on their strategy, they may make a play or wait to see if the stock or index breaks the ‘barrier’ of the line.
How to Use Different Time Frames to Analyze Moving Average
By now you’ve discovered that moving averages can be set to different lengths of time or different speeds.
The faster moving averages (fewer data points) follow the stock price more closely. You can also see that EMA is faster to ‘react’ than SMA because of the effect of the weighting multiple.
Here are a couple of things to consider when using moving average to analyze any chart. I’ll use the 200-day and 50-day moving averages for simplicity.
Key Characteristics From 200-Day Moving Average Chart
The 200-day moving average is often considered a strong gauge of support for a stock’s price. If a stock trends below the 200-day moving average then the trend is clearly down. The 200-day MA is the most common long-term technical analysis indicator.
Key Characteristics From 50-Day Moving Average
The 50-day MA is considered a mid-term indicator. Depending on your strategy, it can give you a much better idea of the recent trend.
The Bottom Line
Traders and market makers hold certain beliefs around common indicators and signals. Moving averages are one of the most common.
The more you understand how market sentiment reacts to prices approaching or crossing a moving average, the better.
There are even entire strategies based on moving averages. It’s a very important part of your education to understand this, even if you don’t trade using moving averages as signals.
Remember, all trades have two sides. Once you understand why people buy and sell, you have a better chance of success. Preparation is key.
— Tim Sykes
Editor, Penny Stock Millionaires