Part 6 of the Technical Analysis classroom deals with understanding the various types of moving averages, and how to decide which one to use while analyzing a stock.
What is a moving average? How is it calculated?
Moving average is an indicator that is used to analyse the price trend of a security. It is an average of the closing price of a security over a specified period of time. A moving average helps the trader to smoothen out the price action by filtering out its daily price movement.
There are two type of moving averages that traders use : Simple and Exponential.
The calculation of the simple moving average of a stock depends on the time period in question. For example: A simple moving average for five days is calculated by taking the closing price of the last five days and dividing the total by 5.
An exponential moving average is calculated by taking the simple moving average and a multiplier for giving higher weights to recent prices.
When the price of a security tends to stay above the moving average, it is known to be on an up-trend and when the price tends to stay below the moving average, it indicates that it is on a down-trend.
Moving average is calculated on historical stock prices. Hence, it is a lagging indicator. Moving averages work well in a trending market and does not work in a choppy market.
What is a simple moving average?
Simple moving average or SMA is simply the average price over a given period of time.
A 50 day SMA on a given day is the average price of the last 50 days of a given security. After the end of a trading day, the earliest price is dropped and replaced by the latest price data for calculating the moving average i.e. it is calculated on a rolling basis
An SMA gives equal weight to all prices for the given time period.
What is an exponential moving average?
Exponential moving average or EMA is the moving average where more weights are given to the recent price data, hence it reacts more significantly to the latest data as compared to a SMA
EMA is calculated by 2 data points : SMA and a multiplier
The multiplier is calculated by the formula [2/(time period+1)]. So for a 50 day moving average, the multiplier would be [2/(50+1)] = 0.0392
The EMA is calculated by the following formula:
Current EMA = (Closing price – previous day EMA) * multiplier + previous day's EMA
where SMA is the simple moving average.
When do you look at an exponential moving average as opposed to a simple moving average?
The calculation makes the EMA quicker to react to recent price changes as compared to SMA
An EMA responds to a price action quicker than an SMA in a short period, which helps the trader to catch the trend earlier.
On the other hand, during a period of consolidation when price spikes can be seen, an EMA responds to them quickly, leading to believe that a trend is forming. Similarly in a trending market, the SMA will be slow to react and one might miss the initial move of the trend.
However, SMA are more smoother than EMA, and it helps the trader to counter fake moves.
- There are many moving averages like 7-day, 14-day, 20-day, 50-day, 100-day, 200-day. How do you decide which one to use while analyzing a stock?
Choosing a moving average depends on what is one’s trading style. Moving averages work because so many traders use it in their trading system. Thus one has to stick to the most commonly used moving averages to get the best results.
A short term trader should stick to an EMA and use shorter time frame moving averages such as 5-day, 10-day, 20-day moving average.
A long term trader can use an EMA or SMA having longer time frames such as 50-day, 100-day, 200-day moving averages.
Initially, 5/10/20/50/100/200 day moving averages were used due to number of trading days in a time frame - 5 days a week , 10 days a fortnight, 20 days a month and so on. Today however, we trade 240 days a year with lesser holidays but the most used moving average is the 200 daily moving average.
A crossover of a fast EMA/SMA above or below a slow EMA/SMA may also denote an official change in trend.
What is a Moving Average Convergence Divergence (MACD)? What is its significance?
MACD stands for moving average convergence / divergence. It is an indicator which reveals the changes in strength, direction, momentum and duration of a trend.
MACD represents a line which is calculated by subtracting a long term (26 day EMA) from a short term (12 day EMA). A 9 day EMA of the MACD line itself is known as the signal line, which functions as a buy or sell signal
When MACD crosses above the signal line, it is a buy signal and similarly when MACD crosses below the signal line, it is a sell signal
The value of MACD is positive when the shorter EMA is above the longer EMA and negative when vice versa.
As the MACD line (faster line) moves away from signal line (slower line), it is called divergence, and as they get closer to each other, it is called convergence.
When the crossovers occur and the fast line (MACD line) moves away from slower line (Signal line) it indicates the formation of a new trend.