Understanding Moving Averages For Technical Analysis

  • Different types of moving averages.
  • Understanding Simple Moving Average (SMA).
  • Understanding Exponential Moving Average (EMA).
  • Drawbacks of SMA and EMA.

Moving average is a very important tool for technical analysis of securities. This has been one of the earliest tools used by traders to find profitable buying and selling points and is still used as a major reference point by traders and investors from all hues. There are different variations of this tool but all of them look at how the “average” of a security is trading and try to remove the noise created by the daily price fluctuations.

The two commonly used tools are for technical analysis are the simple moving average (SMA) and exponential moving average (EMA). The difference between the different types of stock analysis starts with tools like these on technical side and understanding value investing on fundamental analysis side.

Simple Moving Average (SMA)

This is one of the simplest types of moving average in which the arithmetic mean of the past few trading sessions is calculated. This is done by adding the closing price of the past trading sessions and then dividing the sum by the number of trading sessions.

We can understand this by looking at the recent closing price of a Google:

Week 1 (01/26/2015 - 01/30/2015): 536.7, 521.2, 512.4, 513.2, 537.6

Week 2 (02/02/2015 - 02/06/2015) : 532.2, 533.3, 526.1,  529.8 , 533.9

Simple moving average for 5 days will be:

Trading session Price SMA (5)
1 536.7 *
2 521.2 *
3 512.4 *
4 513.2 *
5 537.6 (536.7+ 521.2+ 512.4,+513.2+ 537.6)/5= 524.2, Day 1 to 5
6 532.2 (521.2+ 512.4,+513.2+ 537.6+532.2)/5= 523.3, Day 2 to 6
7 533.3 527.5, Day 3 to 7
8 526.1 530.1, Day 4 to 8
9 529.8 533.4, Day 5 to 9
10 533.9 532.6, Day 6 to 10

*Initial 4 days do not have a mean.

Moving averages smooth out any price fluctuations by averaging out the peaks and lows. At the same time they lag the actual price movement, both during bullish period as well as bearish trend. Also, a longer period moving average would be smoother than a shorter period moving average. Many traders use two or more moving averages in conjunction to find trends and momentum within the market.

Let’s look at how this tool is used to find an ideal entry/exit point:

ma1
Fig 1: Facebook’s SMA (20) (GREEN LINE) and SMA (50) (PURPLE LINE) used along with the price movements.

When SMA (20) crosses SMA (50) line from belowa, a clear signal is given that the overall trend is bullish and points towards an upward momentum in the stock. Instead of looking at the daily fluctuations of the price the traders can use this crossover point as an ideal time to invest in the stock. We can see from the above image that this momentum continued for a good period of time and gave good returns till the next crossover which signaled that the bullish trend is over.

For longer term investing horizon SMA (50) and SMA (200) are taken into consideration to find the ideal crossover points and look at the overall trends.

Exponential Moving Average

The simple moving average (SMA) has a major flaw. It gives equal weightage to all the data points in the past and then finds the mean. Traders on the other hand want a tool which gives more importance to the recent changes in price. Exponential moving average (EMA) provides an average where the recent prices are given more weightage. We can look at the difference between SMA and EMA in the following image:

ma2
Fig 2: EMA follows the price changes more closely than SMA as it gives greater weightage to recent price movements. In the image the purple (EMA, 20) line is able to follow the price more closely than green (SMA, 20) line both during uptrends and downtrends.

For short term trends a smaller length of period is used. Generally a shorter trading horizon uses (EMA, 12) and (EMA, 26) to find ideal trading points. 12 and 26 refer to the average counted over 12 days and 26 days.

Similarly a longer investment horizon looks at longer lengths of period. A commonly used method is to find crossover of (EMA, 50) and (EMA, 200). When (EMA, 50) line is ABOVE the (EMA, 200) it signals a bullish trend whereas if it is BELOW the (EMA, 200) line it signals a bearish trend.

Drawbacks Of Moving Average

The biggest drawback of both SMA and EMA charts is that they have a lag when showing the price changes. This reduces their benefit as an early indicator. Most of the traders instead use other tools like MACD and Bollinger Bands to get an early indication of reversal in price movements. SMA and EMA charts are then used to confirm the predictions made by other tools.

Conclusion

These tools are never used in isolation. They depend on the trade horizon of the investor and will be used as an add-on to other tools and analysis. Moving averages have stood the test of time and have also spawned a vast array of other important tools like MACD. Understanding these tools can be a key determinant in making good entry and exit decisions in the stock market.

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