MA (Moving Averages)

Introduction

The world of stocks is vast, and like cryptocurrency, the space has its fair share of volatility, though probably not to the same extent.

In other words, massive price fluctuations in relatively short periods of time can be a thing, so smoothing out a bit of that price data is important, among many other things, which is why we’ll be looking into moving averages here and the role they play within the wider financial landscape.

What is a Moving Average (MA)?

So, what is a moving average, or MA, for short? Simply put, it’s a stock indicator that’s typically used within various technical analyses.

The whole point of them is, as we previously discussed, to basically even out all that price data with the creation of this average price that’s constantly updated.

Now, this same price can be an average of the last five days, 30 days, or any other period.

The Purpose of Moving Averages

But why would someone want to smooth out the prices of those stocks, you might be wondering?

Well, it’s largely because any impacts of short-term and random fluctuations on stock prices over certain time frames can be mitigated, which may make for better and more informed decision-making processes.

Besides that, it can be good for gauging trends too, like whether a price is bullish, bearish, or on track to be either of those.

The next thing it helps with is determining the support and resistance levels, which basically reflect the points when prices stop falling and rising. So, yes, their purpose is quite the important one.

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Types of Moving Averages

Well, it turns out that there is no one way to calculate a moving average, so below we’ll be looking at some of the more popular methods of doing so and what they seek to achieve.

Simple Moving Average (SMA)

A simple moving average (SMA) is literally the easiest one to calculate. Let’s say you’re calculating the SMA for the last five days.

All you have to do is add all the prices during those five days and divide the sum by five. Due to the simplicity of the calculation, SMAs are more commonly used in quick identifications of trends.

Exponential Moving Average (EMA)

As for exponential moving averages (EMAs), their calculation is a bit more complex. The purpose here is to establish more significance for the most recent data points, allowing for more responsiveness. So, the formula for calculating EMA is as follows:

EMA of today = Value today * (Smoothing/1+days) + EMA of yesterday * (1- (Smoothing/1+days))

Although there can be various options for the smoothing factor, the one option that you’ll find people most commonly using is 2, so smoothing in that formula equals 2. If that factor is raised, then the influence those recent data observations have on the EMA is raised too.

But the SMA is also factored in here. Suppose you wish to use 10 days as your number of observations for your EMA calculation. Then you’ll have to wait until that 10th day to get the SMA. On the 11th day, you may then use the previous day’s SMA as the first EMA of yesterday.

Weighted Moving Average (WMA)

With weighted moving averages (WMAs), they’re a bit like EMAs since they can establish more weight to recent prices too, but they’re calculated differently and tend to be more customizable in that you can establish the weighting as you see fit and calculate accordingly.

Though the most popular and recommended method is to give more weight to the latest prices and less to the preceding ones, as we’ll discuss below.

So, let’s say you want to calculate the WMA for the last seven days. What you do is add all the days together (1+2+3…), which will give you 28, and then establish a weighting of 7/28 for today’s, 6/28 for yesterday, and so on.

Then you multiply today’s price with today’s weighting of 7/28, and do the same for yesterday and all the days before. Once done, add all those values together, and you get the WMA you’re looking for.

The difference between EMAs and WMAs is that with the former, that difference of weights between periods may be more “exponential,” like 1.2 or 1.3, as compared to the 1.0 with the WMAs. Considering the weighting we mentioned earlier as a sort of numerical significance that you attach to the prices.

How to Use Moving Averages in Trading

Now that you have a bit of an idea of what moving averages are, you may want to know of the various ways in which you can use them, as we’ll discuss below.

Identifying Trends with Moving Averages

First of all, the more apparent use case would have to be identifying trends sooner since you’re basically averaging out the prices over certain periods instead of going simply by the daily prices alone. Whether the trend is bullish or bearish, with moving averages, some inklings may be perceived earlier on and then acted upon. Or you can opt for those rather well-known crossover strategies, which involve evaluating two moving averages’ intersection to note any possible trading opportunities.

Support and Resistance with MAs

Again, as we mentioned earlier, MAs are also typically utilized for determining support and resistance levels earlier on for the stock. Think of them as peaks and bottoms.

The peak (resistance) is the point at which the price will no longer rise and fall, and the bottom (support) is the point at which the price will no longer drop and is set to rise. Identifying these is integral if you are to make any money from market sentiments.

Moving Average Strategies for Different Trading Styles

Whatever your trading style is, you can be sure that MAs may be worthwhile and warrant your attention. For day traders, MAs would come in handy due to the need for quick decision-making in relatively short periods of time without having to conduct any complicated calculations.

Or whether it be the swing traders looking for some short-to-medium term gains; for them, who require technical analysis to execute their trades, any indicator will surely be helpful. And finally, for those who’re in for the long term, something like a 100-day MA or even more will definitely be of use.

Advantages and Limitations of Moving Averages

So, now that you know what MAs are and how they may be used, it’s time to look at some of the advantages and disadvantages.

Benefits of Using MAs

From what we have discussed so far, it should be quite clear by now that MAs can be good trend indicators, and the time frames in which you want them are quite flexible.

Not to mention their availability; pretty much any major stock trading site or whatnot displays them now and does all those hard calculations for you. How you make use of it, then, is entirely up to you.

Limitations of MAs

But as with anything these days, you can be sure that there is some type of drawback, and MAs are no exception here. For example, depending on the time frame, there will obviously be this lag where it will take a bit of time to determine whether an asset is due for a strong trend upward or downward.

While MAs may help with some of the volatility, in highly volatile markets, there will always be the chance for false signals. You may think that the price is due for recovery only to then see it fall even lower. Sometimes, the market can head in unexpected directions, and MAs may not be as good with that.

Conclusion

Moving averages have proven to be quite the resourceful tool for traders looking to make something of the stock market. Whether it be finding out those downturns or recoveries or providing some historical insights on assets’ performances, there are various ways in which their potential can be tapped, giving traders the means to make informed trading decisions.