TA: Moving Average

A moving average is the average price of a security over a set amount of time.

By plotting a security's average price, the price movement is smoothed out. Once the day-to-day fluctuations are removed, traders are better able to identify the true trend and increase the probability that it will work in their favor.

3 most important MAs:

1. Simple Moving Average (SMA)
-most common
-takes the sum of all of the past closing prices over the time period and divides the result by the number of prices used in the calculation
-For example, in a 10-day moving average, the last 10 closing prices are added together and then divided by 10.


-increasing the number of periods used in the calculation of MA makes the average less responsive to changing prices, and by doing so, it's one of the best ways to gauge the strength of the long-term trend and the likelihood that it will reverse.

2. Linear Weighted Average
-least common
-is calculated by taking the sum of all the closing prices over a certain time period and multiplying them by the position of the data point and then dividing by the sum of the number of periods.
-For example, in a five-day linear weighted average, today's closing price is multiplied by five, yesterday's by four and so on until the first day in the period range is reached. These numbers are then added together and divided by the sum of the multipliers.
-is used to address the problem of the equal weighting. ( Because many individuals argue that the usefulness of SMA is limited because each point in the data series has the same impact on the result regardless of where it occurs in the sequence. The critics argue that the most recent data is more important and, therefore, it should also have a higher weighting. Hence the invention of linear moving weighted average. )

3. Exponential Moving Average (EMA)
-uses a smoothing factor to place a higher weight on recent data points and is regarded as much more efficient than the linear weighted average
-complex calculation method which is not necessary for normal users to understand
-important point: it is more responsive to new information relative to the simple moving average, and hence it's preferable over SMA by most users.


As you can see in Figure above, a 15-period EMA rises and falls faster than a 15-period SMA. This slight difference doesn’t seem like much, but it is an important factor to be aware of since it can affect returns.

Major Uses of Moving Averages

-to identify current trends and trend reversals
-to set up support and resistance levels.
-to quickly identify whether a security is moving in an uptrend or a downtrend depending on the direction of the moving average
-to look at the order of a pair of moving averages: When a short-term average is above a longer-term average, the trend is up. On the other hand, a long-term average above a shorter-term average signals a downward movement in the trend.


As in the above figure, when a moving average is heading upward and the price is above it, the security is in an uptrend. Conversely, a downward sloping moving average with the price below can be used to signal a downtrend.

Moving Average Reversal:
formed in 2 ways

1. when the price moves through a moving average
For example, when the price of a security that was in an uptrend falls below a 50-period moving average, like in the figure below, it is a sign that the uptrend may be reversing.


2. when one moving average crosses through another
For example, as in figure below, if the 15-day moving average crosses above the 50-day moving average, it is a positive sign that the price will start to increase.


If the periods used in the calculation are relatively short, for example 15 and 35, this could signal a short-term trend reversal. On the other hand, when two averages with relatively long time frames cross over (50 and 200, for example), this is used to suggest a long-term shift in trend.

Reversal at MA

It is not uncommon to see a stock that has been falling stop its decline and reverse direction once it hits the support of a major moving average. A move through a major moving average is often used as a signal by technical traders that the trend is reversing. For example, if the price breaks through the 200-day moving average in a downward direction, it is a signal that the uptrend is reversing.



Conclusion

The most common time frames that are used when creating moving averages are the 200-day, 100-day, 50-day, 20-day and 10-day. The 200-day average is thought to be a good measure of a trading year, a 100-day average of a half a year, a 50-day average of a quarter of a year, a 20-day average of a month and 10-day average of two weeks.

Moving averages help technical traders smooth out some of the noise that is found in day-to-day price movements, giving traders a clearer view of the price trend.




Venus

ps: Content and pictures in this article are excerpted from Investopedia.