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Stock markets tend to experience significant swings and trend reversals. If they do so, it may be difficult for traders to determine the right price for them to trade or leave a stock/commodity.
As savvy traders, we utilize the power of moving averages in stock price analysis to decode short-term and long-term trends in financial and technical trading. In addition to stock price analysis, the moving average has other potential applications as an additional indicator for trading signals.
The moving average ribbon is the most common and simple method used.
What then is a moving average, and how is it important to you as a trader?
Let’s find out!
What Is the Moving Average Indicator?
A Moving average indicator helps traders to analyze the prices of stocks.
The moving average indicator selects prices for fundamental security over several data points and obtains their averages to provide the median price.
The moving average indicator helps resolve securities’ fluctuating prices over a given period.
As a trader looking to enter or exit from stocks and commodities, the moving average indicator can assist you in planning your entry or exit strategy.
The indicator usually uses a security’s past information because it is a lagging indicator. A lagging indicator as it trails the price action of the underlying asset. Many traders usually overcome this problem by conducting additional fundamental and technical analyses.
Why Is this Indicator Referred to as ‘Moving’?
The indicator is referred to as ‘moving’ because of its constant re-assessment when discovering new data points.
The following example may help you understand better.
Suppose Stock X Ltd.’s five-day closing prices are 101, 102, 107, 105, and 103, respectively.
This means that the 5-day moving average for the week is 103.
Moving on to the next week, and assuming that the available price data is 106 and 100, the 5-day simple moving average indicator will automatically take these new prices as the latest data points.
Thus, the indicator will thus ignore the first week’s data points on days 1 and 2 (101 and 102).
The new calculation for week two’s 5-day moving average will thus be an average of the prices as below:
Moving Average for Week 2 = (106+100+107+105+103)/5
Thus the new 5-day Moving Average for Week 2= 104.2
What are the Different Types of Moving Averages?
Many ways of calculating moving averages exist, with each method giving varying results.
However, the two most common moving averages are the: Simple moving average (SMA) and Exponential moving average (EMA).
The Simple Moving Average (SMA)
An SMA is formed by computing the average price of a security over a specific number of periods.
The indicator adds all the data points within a given period and divides them by the existing data points.
The simple moving average will help determine your entry and exit points if you are a trader.
You can use the following formula to calculate the SMA.
SMA= (P1+P2+P3………Pn)/n, where 'P' represents the data points while 'n' is the actual number of data points.
The Exponential Moving Average (EMA)
Unlike the simple moving average that assigns equal weights to all the data points under consideration, the EMA gives more weight to recent data points than previous ones.
The goal is usually to ensure that the average responds more to price changes.
You must assign weights to all the data points. You should also assign more weights to future data points than previous ones.
The following are the steps you should use in calculating EMA.
Determine SMA:You should start by determining the simple moving average. You can also use the previous day’s close price as the starting point.
Calculating the Multiplier:You will calculate the multiplier using the formula: Multiplier = 2 / (Chosen time frame + 1).
Finally, Calculate the EMA:Calculating the EMA is the final step and will incorporate the following formula:
(Today's Price * Value of multiplier) + EMA yesterday * (1-multiplier value)
How Can You Use the Moving Average Indicator to Identify Trading Opportunities?
Having understood the meaning and main concepts behind moving averages, it is now crucial to understand the importance of moving averages in trading.
You should consider a support point as a good entry place to buy positions, with a resistance point being a place where you can logically exit buy positions or enter sell positions.
The data is clutched by both analysts and investors as they aim to decipher which is the potential direction of the asset price.
You should note that the bigger the moving average, the more impact it will have on support and resistance levels.
Thus, you should use larger moving averages as long-term indicators and smaller moving averages as short-term indicators. The period of smaller moving averages could be 14 days.
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