What is a Moving Average?
A Moving average is a Technical Indicator that traders and investors may use to determine the trend of the market. A moving average indicator helps smooth out the price data by creating an average price. Analysts use the moving average to examine support and resistance levels by evaluating the previous price action or movement of a security’s price.
The moving Average is a customizable indicator. Traders can choose whatever time frame they want when calculating an average. It is a trend following indicator, which means it is Lagging in nature. The longer the time period for the MA, the greater the lag is. The most common MAs are 15, 20, 30, 50, 100, and 200-day moving averages.
Types of Moving Averages
Simple Moving Average (SMA Indicator)
The simple moving average is the simplest form of a Moving average. It is calculated by summing the recent data points in a given set and dividing the total by the number of time periods
SMA= A1+A2+…+An / n, Where A is average and n is the number of the time period
SMA is a backward-looking indicator as it relies on past price data for a given period. Traders and investors use SMA to generate buy or sell signals.
Exponential Moving Average (EMA Indicator)
The Exponential Moving Average is a type of Moving Average that gives more importance to the recent price, so as to make it more relevant to the new information. Therefore an exponential moving average tends to be more responsive to the most recent price change as compared to the simple moving average.
To calculate an EMA a trader first has to compute the simple moving average. After that calculate the multiplier for weighting the EMA. (generally known as the smoothing factor).
Formulae for Calculating Multiplier: [2/(selected time period + 1)]
Then you use the smoothing factor combined with the previous EMA to arrive at the current value. As a result, this gives a higher weightage to recent prices.
Moving average vs Exponential Moving average (MA vs EMA)
The main difference between the two technical indicators is the importance that they pay to the price data. The exponential moving average tends to place more importance on recent price changes. As a result, EMA is more responsive to the latest price changes. While SMA is a less responsive and more lagging indicator as compared to EMA
Calculating Moving Averages whether Simple moving averages or exponential moving averages can be tricky. however, Most charting Softwares provide traders with moving average indicators.
How to Trade with Moving Averages?
Price Crossover Strategy
While using this Strategy it is suggested that A trader uses EMA rather than SMA. When the Moving Average crosses the price from below to above, Buying signal is triggered. Similarly, When the Moving Average crosses the price from above to below, It is considered a Sell signal.
Moving Averages Crossover Strategy
Another way to trade with Moving Average is to apply 2 moving averages to a chart. A long-term MA preferably a 50-day EMA and a Short term EMA preferably a 9-day EMA. Now, When the shorter EMA crosses above the longer EMA, it is a buy signal. Whereas when the shorter EMA crosses below the longer EMA, It is a sell signal.
The moving Average is an Indicator that smoothes out data and helps identify the trend clearly. EMA is quicker and more sensitive to recent price changes than the SMA, which gives a trader a little extra edge, but in some cases, it may generate false signals. This is why it is recommended to use Moving Averages with other Techincal tools such as MACD, Candlestick patterns, Fibonacci retracement, and Price action. MA can also highlight areas of potential support and resistance levels.