What are Moving Averages?
Moving Averages are a key part of technical analysis, and a concept that should be learnt by all traders. They are designed to help you spot the trend of any instrument you may be trading, and are based on using the price changes of the underlying asset, to create an informative line on a chart. This line can help you make numerous trading decisions and is a vital companion to successful trading. Moving Averages (MA’s) also form the basis of many other, more advanced, technical tools - so their importance cannot be understated.
To get started, it is helpful to understand the basic trait of MA’s, these being that a long-term average (say a 200-day average) is slower to react to underlying trends than a short-term average (say a 50-day average). This is the key to understanding Moving Averages.
Let’s start with the most basic type of MA and how it works, the Simple Moving Average (SMA):
Simple Moving Averages smooth the price data of any instrument to form a trend following indicator. It is done by calculating the average price of an instrument over a specific number of periods. Usually the Simple Moving Average is based on the closing price.
Let’s say you want to work out the 10-day Simple Moving Average for Gold. To do that, you’d look up the closing price for gold over the past 10 days, add them together, and then divide by 10. This will give you only the 10-day average. But as a Moving Average is an average, it therefore naturally moves as old data is dropped and as new data comes available.
In other words, the first day of the Moving Average covers the last 10 days, while the second day of the moving average drops the first data point and adds the new data point. The following days continue by dropping the latest data and adding the new data.
Below you can see the SMA10 on a chart of daily Gold prices.
Exponential Moving Average (EMA)
It’s very similar to a Simple Moving Average except there is more weight on the latest data. EMA reacts quicker than the SMA, which means that it turns before the SMA so it's more sensitive to recent prices.
To determine the EMA, you need to use the SMA as the starting point of your EMA calculation. Then you also need to calculate the weighting multiplier by applying this formula:
(2 / time periods + 1).
Taking the previous example, if you want to determine a 10-day EMA, you will get 0.1818 (18.18%) as a multiplier by using the above-mentioned formula (2 / 10 + 1). And then you can calculate the Exponential Moving Average with the formula below: EMA = ((daily closing price - EMA(previous day)) x multiplier + EMA(previous day)) Don’t forget EMA starts with SMA, so when you are applying the previously mentioned EMA formula, at the first calculation you need to replace EMA (previous day) with SMA (previous day). Whilst this may appear confusing at first it is actually very simple to visualise on a chart.
To compare the SMA and EMA see the chart below.
Blue = EMA
Red = SMA
Interpretation of Moving Averages
Moving Averages (both simple and exponential) can be useful if you want to identify the trend direction by using one particular Moving Average, or if using more than one, by observing any crossovers of MA’s.
If you want to use a Moving Average for trend identification, you need to watch whether the price is below or above the Moving Average. If the price is above and the Moving Average is rising, it shows prices are generally increasing. If the price is below and the Moving Average is falling, it reflects that the prices are generally decreasing.
Crossovers of Moving Averages can help you to determine shifts in momentum and also provide perhaps the most basic signals for entries and exits. This occurs when the two Moving Averages (one shorter-term and one longer-term) cross each other. For example: if a short-term Moving Average moves upwards through a long-term one, that’s a sign that prices could continue heading up. If the short-term average comes down through the long-term average, it could be a sign that prices are about to tumble. Please find below an example for the SMA crossovers.
Blue = SMA50
Red = SMA10
In addition, some traders believe that MA’s (especially SMA’s) also act as support or resistance levels. Their belief, is that if the price is getting close to the MA, there can be a reversal of the trend. Usually, the 20, 50, 100 and 200 period SMA’s are most perceived to act as support or resistance levels, and hence these are the most popular ones.
Setting up MA in your Skilling platform
The set-up interfaces of SMA and EMA are the same. You can adjust the following:
Period: More common Moving Averages are 14, 21, 50, 100 or 200 days.
Type of price: ‘Close’, ‘Open’, ‘Low’ or ‘High’,
Moving Averages are an absolutely vital part of technical analysis. In fact, we would go so far as to say that this is a top area to learn and master from the Skilling Academy! If you are new to trading, you re-read the article and then really start to play around with all the various types of Moving Averages on the Skilling platform. You will find the basics to many strategies used by novice to professional traders across the globe. They form one of the key basic components of all technical analysis.