In the world of finance, a Moving Average (MA) is a commonly used tool in technical analysis to understand stock behavior. The purpose of calculating a moving average for a stock is to create a regularly updated average price, helping to smooth out the ups and downs in its price data.
By using the moving average, we aim to reduce the impact of random, short-term price fluctuations on a stock over a specific time period. There are two main types of moving averages: Simple Moving Averages (SMAs), which calculate a basic average of prices over a set timeframe, and Exponential Moving Averages (EMAs), which give more importance to recent prices compared to older ones over the same timeframe. This distinction helps provide a clearer picture of the stock’s overall price trend.
How does the Moving Average MA work?
Moving averages are mathematically determined to figure out which way a stock is heading or to pinpoint levels where it might find support or face resistance. They fall into the category of trend-following indicators, sometimes referred to as lagging, because they rely on historical prices.
The length of time chosen for the moving average affects how quickly it catches up to the current state of the stock. A 200-day moving average takes longer to catch up compared to a 20-day moving average because it considers prices from the past 200 days.
Investors and traders closely track the figures for the 50-day and 200-day moving averages, as they are recognized as significant signals for making trading decisions.
Investors can pick from various time periods to calculate moving averages based on their specific trading goals. Shorter moving averages are usually chosen for short-term trading, while those with longer periods are better suited for long-term investors.
Even though predicting the exact future movement of a specific stock is impossible, using technical analysis and research can improve the accuracy of predictions. A rising moving average suggests that the security is on an upward trend, while a falling moving average indicates a downward trend.
In a similar vein, upward momentum is confirmed by a bullish crossover, which happens when a short-term moving average moves above a longer-term one. Conversely, downward momentum is confirmed by a bearish crossover, which occurs when a short-term moving average dips below a longer-term moving average. These crossovers act as signals for potential changes in a stock’s direction.
Types of Moving Average (MA)
Simple Moving Average
is a straightforward calculation. It involves adding up a set of values, like stock prices, and then dividing the total by the number of values in that set. Essentially, it’s finding the average of a specific set of numbers over a defined period.
Exponential Moving Average
The Exponential Moving Average (EMA) aims to give more importance to recent prices, making it more responsive to new information. Here’s how it’s calculated:
- Start with the Simple Moving Average (SMA): Calculate the SMA over a specified time period.
- Determine the Smoothing Factor: This is like a multiplier that influences the EMA’s responsiveness. The formula for the smoothing factor is [2/(selected time period + 1)]. For instance, with a 20-day moving average, the multiplier would be [2/(20+1)] = 0.0952.
- Combine Smoothing Factor with Previous EMA: The smoothing factor is then combined with the previous EMA to calculate the current value. This process ensures that the EMA gives more weight to recent prices compared to the SMA, which treats all values equally.