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PR15 - What Are Moving Averages?

"Moving averages are the basic technical indicators built upon mathematical values. These are one of the oldest technical indicators based on which, one can build up either a complex or a simple trading system. This includes automated trading systems as well. As the name suggests, a moving average simply shows the average of the price to which it is applied. The name moving comes because these average prices are constantly plotted on the charts as and when they occur. There are different types of moving averages that can be used. In this article, we take a look at what are moving averages and how they work. You will also learn about the different moving average types and how they differ including how using the lookback period can affect the value of the moving average. As a trader, it is quite likely that you will use moving average indicator at some point in your trading. Therefore, this article gives you the basics of using this indicator."

Moving averages are one of the simplest of all technical indicators. They are widely used in a number of technical trading systems, both simple as well as complex. The concept of moving averages is based on the mathematical expression.

As the name suggests, a moving average indicator constantly plots the average price of the security that is being analyzed. This is plotted as a continuous line on the chart.

The moving average basically tells the technical analysis whether the markets are bullish or bearish, depending on how price of the security is positioned.

For example, when the price of the security is above its moving average, it indicates that the markets are bullish. Likewise, when the price of a security is below its moving average, it indicates that the markets are bearish.

The moving average indicator is known as a lagging indicator. This is because it compares the different price points and then derives the values. In technical analysis, moving averages are used as a trend determination indicator or even as a dynamic support and resistance indicator.

The ability of the moving average to adjust to the time period of your choice makes it a very flexible indicator to work with. You can calculate moving averages based on various price levels as well, including open, close, high, low as well as median price values too.

Types of moving averages

There are different types of moving averages that are widely used. Firstly, the chart below shows the different moving average types. As you can see, there are no big differences between the way the moving averages are calculated.

PR15 01 Types Moving Average

Types of moving averages

 

The Simple Moving Average (SMA)

The Simple moving average uses the arithmetic mean for the price points. This is the moving average price of the security. As price evolves and new sessions are formed, the old values are discarded, and the new moving average is formed.

Depending on the lookback period, the moving average takes into account only the pre-determined set of values. The simple moving average is of course the simplest of all. But the main drawback is that the SMA doesn't give more weight to newer price values.

The Exponential Moving Average (EMA)

The exponential moving average addresses the short comings of the SMA but giving more value to the recent price points. This is done by giving the more recent price values higher weightage compared to older values. Thus, the EMA is more receptive to price volatility.

The Linear Weighted Moving Average (LWMA)

The Linear weighted moving average as the name suggests gives great weigh to the more recent price points. However, the weightage given is linear and this the recent set of data is treated the same way.

The Smoothed Moving Average (SMMA)

The Smoothed moving average basically starts off as an exponential moving average. However, these values are further smoothed. The SMMA takes into account all the values rather than treat the more recent price levels.

The moving average periods

Depending on what time frame you use, the moving averages use something called a lookback period. This is the dataset or the input that you give into the indicator. For example, if you are using an SMA with 5 period look back, it means that the average price of the past five closing price levels are indicated by the SMA.

Some of the most commonly used lookback periods include, the 200-day moving average, ,100-day moving average and the 50-day moving average. You can of course change the values of these moving averages. Traders also experiment with Fibonacci numbers such as 38, 21 and so on.

The moving averages by themselves do not give out too much information. Traders often employ two or more moving averages to understand the market context. Typically, traders employ a short term moving average and a long term moving average.

When the short term moving average crosses over the long term moving average, it signals that the markets are bullish. Likewise, when the short term moving average crosses below the long term moving average, it signals that the markets are bearish.

This is pretty straightforward as it tells you the bullish and bearish markets depending on how the average prices of the short term and the long term are lined up.

Many traders tend to spend a lot of time in trying to figure out which moving average type and the period is the best. The answer is that there is no straight way to this question. The moving averages are dynamic and simply indicate the trend.

Depending on the time period and your trading style, you could potentially make use of any of the moving average types and periods. However, we should mention that among the different moving averages, the EMA is most commonly used.

Read 637 times Last modified on Sunday, 14 July 2019 08:50

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