Moving averages (MA) are a very common technical indicator. This tool comes in many forms, such as simple, exponential, and weighted. Additionally, you can use MAs with other indicators to create trade signals.
This post will break down what moving averages are, the different types, why people use them, and a few disadvantages.
What are Moving Averages?
A moving average is a type of technical indicator. It “smooths out” the data and creates an average price over the selected period of time. This means that it will filter out small, short changes in price. The period of time can be anything, from one minute, 1 day, 1 week, 1 month, and more. This type of indicator is very popular and used by long and short term traders and investors.
Read More: Beginner’s Guide: Technical Analysis
Types of Moving Averages
Simple Moving Average (SMA)
Simple moving averages can be calculated by any time frame. It is calculated by taking that closing prices of the desired time frame and dividing it to get an average price. This is not something you’ll likely have to calculate by hand—many trading platforms and charting tools will have this, and other MAs built-in.
For long-term investors, 50-, 100-, and 200-day MAs are common time frames to use. For shorter-term averages, 5-, 10-, and 20-day moving averages are common.
Exponential Moving Average (EMA)
Exponential moving averages are calculated by taking the closing prices of the desired time period but giving more weight to the recent prices than the past prices. The benefit of this is that it reacts quicker to price changes.
Similar to SMAs, these can easily be found in your trading or charting platform.
Weighted Moving Average (WMA)
Similar to EMAs, weighted moving averages place more weight on the recent closing prices, and less for the older closing prices. The main difference is that WMAs are calculated differently and are more easily customizable.
Moving Average Convergence Divergence (MACD)
Moving average convergence divergence, or MACD, is a common technical indicator that is based on moving averages. It measures the strength of a trend and uses two moving average prices. The MACD is the 12-period EMA minus the 26-period EMA.
Why Use Moving Averages
SMAs, EMAs and WMAs reduce noise on charts by “smoothing” out the data that may show short-lived price changes. It makes it easy to read and detect trends.
You can use moving averages when analyzing a stock to highlight its price trend. If the price is higher than the moving average, it is showing you the stock is trading higher during the selected period, on average. If the price is lower than the moving average, it is showing you that the stock is trading lower during the selected period, on average. This can help confirm up or downtrends.
Some moving averages may also act like support or resistance lines. For example, 50-, 100- or 200-day averages could act as support or resistance lines.
Some people will combine MAs and use other indicators to create their own trading signal that fits with their strategy. One example of this is added a short-term MA and long-term MA. If the short-term MA crosses the longer-term MA, some interpret that as a buy-signal for an uptrend. This is known as a golden cross. Remember to do the proper research on golden crosses before using it as a buy signal for yourself.
Disadvantages of Moving Averages
One disadvantage of moving averages is that it is based entirely on historical data—nothing about it is a prediction. Just because the moving average is in uptrend doesn’t mean the stock will continue that direction
Additionally, MAs work best in trending market conditions. When the market gets choppy, they are not as reliable.
MAs are a helpful tool for traders, making it easier to spot price trends. Most trading platforms and charting tools will over a variety of options for you to choose from, depending on your strategy and what you’re looking to trade.