Moving averages is used to describe the average price of a security over a specific period of time and it’s one of the most commonly used variables in the technical analysis of a stock’s performance. Depending on the time-frame analysis being conducted, this could be anywhere from 20, 30, 50, 100 or 200 days. The time duration is determined and used to isolate price trends by flattening out large fluctuations.
How Moving Averages are Determined
The data created by determining the averages is how chartists follow whether a stock’s price is trending up or down. As each new day’s (or week’s or month’s) numbers are added to the average, the oldest numbers are removed, thus the average is always "moving."
Types of Moving Averages
Moving averages vary in the way they are calculated and for these reasons there are a number of different specific types used in technical analysis. However, while the methods used to calculate the data may differ, the average is still interpreted the same way. The most common types of moving averages are:
Simple Moving Average
SMA is the most common method used for calculating the moving average of a price. In this method, the closing prices for each day of the period are added together and then divided by the number of prices used in the calculation. For instance, if a 20-day period is being calculated, the 20 closing prices are added and divided by 20. The resulting number is the simple moving average. The more time periods used in the calculation, the better a trader can gauge the long-term strength of the stock.
Linear Weighted Average
To determine the linear weighted average, the sum of all the closing prices over a certain time period are multiplied by the position of the data point. Then, these numbers are added together and then divided by the sum of the multipliers. For instance, to determine a five-day linear weighted average, today’s closing price is multiplied by five; yesterday’s closing price is multiplied by four and so on until you reach the first day of the period. These numbers are added together and then divided by five. The resulting number is the linear weighted average for the five-day period.
Exponential Moving Average
EMA is considered a more efficient calculation than the linear method as it uses a smoothing factor to place a higher weight on recent data points. Technical traders prefer EMA due to the fact that it is more responsive to new information relative to the SMA.
Moving Averages Technical Analysis
Moving averages technical analysis determines the security’s momentum over a period of time and often incorporates the comparison of two different averages. For instance, during an analysis, the short-term average is compared with the long-term average.
• If the short-term average is higher than the long-term, then the trend is considered up
• If the long-term average is above the short-term, then it typically signals that the trend is in a downward movement
When analyzing moving averages, trend reversal is formed through two ways. The first is when the price moves through an average and the second is when the price move through average crossovers.
Moving average technical analysis also uses the averages to identify resistance and support levels. Once the price moves through a major average, it is commonly seen by technical traders that the trend is reversing. Technical traders also utilize moving averages to help reduce much of the noise that can exist in day-to-day price fluctuations so they have a clearer picture of the stock’s trend.
If you are interested in applying moving averages technical analysis to your stock picks, you may want to consider signing up for a risk-free 14 day free trial of SmarTrend – and take the guesswork out of your trading.
Next: Technical Analysis: Oscillator/Indicator