While some technical indicators are more popular than others, few have proved to be as objective, reliable and useful as the moving average. Technical traders track the trends of financial assets by smoothing out the day-to-day price fluctuations, or noise.

The simplest form of a moving average, the simple moving average (SMA), is calculated by adding the closing price of the security for a number of time periods and then dividing this total by the number of time periods. Short-term averages respond quickly to changes in the price of the underlying, while long-term averages are slow to react. For example, to calculate a basic 10-day moving average you would add up the closing prices from the past 10 days and then divide the result by 10. Keep in mind that equal weighting is given to each daily price. Many traders watch for short term averages to cross above longer-term averages to signal the beginning of an uptrend. Short term averages, like a 10-period SMA, act as levels of support when the price experiences a pullback. Support levels become stronger and more significant as the number of time periods used in the calculations increases.

While a 10-day moving average represents the trend in prices through a period of 10 days, a longer 25-day moving average is smoothed more than a 10-day moving average with each new day’s data making less of an impact on the calculation of the moving average value than a shorter-term moving average. An even longer-term moving average, such as a 100-day moving average, is plotted to identify longer-term trends in price.

By creating an average of prices that “moves” with the addition of new data, the price action on the market being analyzed is smoothed. So, by calculating the average value of an underlying security or indicator, day-to-day fluctuations are reduced in importance and you get a stronger indication of the trend of prices through the period being analyzed.

By identifying trends, moving averages allow traders to make those trends work in their favor and better confirm a trend. Once determined, the resulting average is then plotted onto a chart to look at smoothed data rather than focusing on the day-to-day price fluctuations that are inherent in all financial markets.

SIMPLE MOVING AVERAGES

SMA = (P1 + P2 + P3 + Pn…) / N

Where,

P1 = Price for day one

P2 = Price for day two

P3 = Price for day three

N = Number of days in the moving average

In its simplest form, moving averages are less effective than when used as an exponential moving average or in combination with other moving averages in crossovers.

EXPONENTIAL MOVING AVERAGES

An exponential moving average (EMA) is calculated by adding a percentage of yesterday’s moving average to a percentage of today’s closing value. This way, traders can put more emphasis on more recent data and less weight on past data in the calculation of the moving average. The most commonly used moving average is the exponential moving average based on closing prices without any shift. Learning the somewhat complicated equation for calculating an EMA may be unnecessary because almost all charting packages do the calculations for you.

EMA = (P * S) + (Previous EMA * (1 - S)),

Where,

P = Current price

S = Smoothing factor, which is 2 / (1 + N)

N = Number of time periods

When using the formula to calculate the first point of the EMA, you will notice there’s no value available to use as the previous EMA, for this just start the calculation with a simple moving average and continue on with the above formula from there.

“The basis of interpretation is to buy when the market price moves above its moving average and to sell when the price moves below its moving average. Different lengths of averages are meant to identify different trends,” says Casey Murphy, senior analyst at ChartAdvisor.com and writer for Investopedia.com.

He says short-term trends are often best identified by a five- to 15-day moving average; minor intermediate trends are roughly 20 to 50 days; intermediate trends range from 50 days to 100 days; and long-term trends are greater than 100 days, usually 200 days. The length of the moving average should match the cycle or trend you wish to follow.

Another way to use moving averages is to use crossovers. Plotting two moving averages can provide signals for trading when a shorter moving average crosses a longer term moving average. The trade off is between timeliness and possibility of whipsaws. (See sidebar story “Understanding crossovers.”)

USING MOVING AVERAGES

A basic approach to using moving averages is to identify which term of price trend you wish to monitor and then produce an appropriate period moving average. In this approach, when a market’s price is above the moving average it is an indication of bullish behavior.

When price is below the moving average it is an indication of bearish behavior in relation to the trend length being viewed. When price falls from above the moving average to below the moving average it warns that the price trend being viewed may be weakening. When price rises from below the moving average to above the moving average, it is a bullish indication of the price trend length under scrutiny. The shorter the term of a moving average, the more susceptible these signals are to whipsaws.

A second approach is to plot two or more moving averages and look for crossover points to help identify periods of significant change in underlying bias for the tradable market. When a shorter term moving average crosses from below to above a longer period moving average it is a sign of bullish bias. When a shorter-term moving average crosses from above to below a longer period moving average it is a sign that a bearish bias is present in price trend development.

“Following the moves,” below, shows a good example of how traders use moving averages to generate signals. The bearish crossover (blue line cross below red line) is used as a sell signal because prices have been moving lower in the short term at a faster rate than it has dropped in the past. Conversely, the bullish crossover (blue cross above red) is used as a buy sign because prices have been rising at a faster rate than in the past.

Because most moving averages represent the average of all the applicable daily prices, it should be noted that the time frame does not always need to be in days. Moving averages can also be calculated using minutes, hours, weeks, months, quarters, years, etc. “Why would a day trader care about how a 50-day moving average will affect the price over the upcoming weeks? On the other hand, a day trader would want to pay attention to a 50-minute average to get an idea of the relative cost of the security compared to the past hour,” Murphy says. Some traders may even use the average price during the past five minutes to gauge an uptake in short-term momentum.

As you know, nothing in the financial markets is for certain — certainly not when it comes to using technical indicators. “If a stock bounced off the support of a major average every time it came close, we would all be rich,” Murphy says. “One of the major disadvantages of using moving averages is that they are relatively useless when a market is trending sideways, compared to the times when a strong trend is present.” Don’t forget that moving averages lag and you should always use another indicator to confirm moving average signals.