Moving Average

A moving average (MA) is an indicator used in trading that displays the market price average over a specified period. Traders use it to reveal possible support and resistance areas. It spots trend directions while filtering out price fluctuations noise.

An uptrend is confirmed if market prices are above the MA while the opposite is the case for a downtrend. This tool detects trend changes by observing market crosses. If the market price crosses above the moving average, the trend has changed to an uptrend. However, when the market price crosses beneath it, the trend has switched to a downtrend.

Nonetheless, a shortcoming of MAs is that they cannot predict prices, but only reveal current market directions with a lag. So its purpose is to flatten prices and show the current trend direction. There are two types of MA – Simple Moving Average (SMA) and Exponential Moving Average (EMA).

Computing SMA:

SMA is formed by obtaining the closing price of a market over a specific number of periods. For instance, the five-day moving average is the last five closing prices’ sum divided by five. As new prices are added, old prices are discarded, leaving the current five prices. Here’s an illustration of a five-day SMA:

Market data: 100, 101, 102, 103, 105

SMA: (100 + 101 + 102 + 103 + 105) ÷ 5 = 102.2

Computing EMA:

EMA applies more weight to current market prices than SMA, leading to reduced lags. Three steps are involved when calculating EMA. The first is computing SMA because it provides a starting point for EMA. Second is calculating the week multiplier, and last is determining the EMA. Here’s an example of a ten-day EMA:

Market data: 100, 101, 102, 103, 105

Time Period: 10

SMA: (100 + 101 + 102 + 103 + 105) ÷ 5 = 102.2

Multiplier: (2 / (10 + 1)) = 0.1818

EMA: (Close – EMA (previous day)) x multiplier + EMA(previous day)

Author: Brady C Preston

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