Moving Averages are another tool used in the technical analysis of stocks by traders and they can be helpful in such times when fluctuation is high in the stock price. Every time it is not so easy to identify the trend in the stock market for a stock price. Sometimes the price of a stock can vary abruptly or very quickly in a short span of time with great fluctuations. In this scenario of heavy fluctuations, it becomes very difficult to identify the accurate trend of the stock price in which direction the price is going.
There are different types of MA’s like Simple Moving averages (SMA), Exponential Moving averages (EMA) linear weighted averages (LWA) which a trader uses in its trading.
What is the Moving Average?
It is an indicator used in the technical analysis of the stock and it depicts the averages of the past stock prices to the trader. It is called moving because it keeps on recalculating its data points and averages by taking the latest stock price data. Traders also use these to find the support and resistance for the stock price. By using these previous data, a trader can identify a potential trend in the stock price.
The moving average indicator is a lagging indicator because its output value depends on the past prices of the stock. The greater the timeframe used in the calculation of the average, the more degree of lag will be there. For example, a 50-day MA will have a greater degree of lag with respect to 20 days MA. But as long as the timeframe for calculating averages, the less sensitive it will be to the price changes. That means a 50 days MA will be less sensitive to a price change as compared to a 20 days MA. Usually, short-term MA is used by short-term traders while longer MA is used by investors.
But this moving average indicator is a fully customizable indicator which means a trader can select the time frame as per his requirement.
How to read Moving Averages
It is not possible to predict the stock price but by using a Technical Analysis of the stock, a somewhat informed decision can be taken by the traders. If the MA indicator is rising i.e. moving upwards that means it is an indication of an uptrend. While If the indicator is falling i.e. moving downwards that means it is an indication of a downtrend. Confirmation of the trend is taken with the crossovers of the short-term Moving Average line with the long-term Moving Average line.
If the short-term MA crosses above the long-term MA in the upward direction means it is a bullish crossover so it can be a confirmation of a bullish trend. If the short-term MA crosses below the long-term MA in the downward direction means it is a bearish crossover so it can be a confirmation of a bearish trend.
Types of Moving Averages
There are different types of moving averages used by the indicators in the technical analysis of the stock.
Simple Moving Average (SMA)
Simple Moving Average (SMA) as its name indicates, calculates the arithmetic mean of the stock price over a given timeframe by simply adding the total stock price in that timeframe and dividing it by the number of market days in that timeframe. This indicator is used by traders to take the best trade by selecting the best entry and exit times. The SMA indicator is a lagging indicator because its calculated indication depends on the stock price of the past time frame. It also helps to discover support and resistance at the price level to make the best trading decision.
SMA = (D1 + D2 + ……….Dn) / n
Where D1, D2…… Dn is the stock price of days n is the number of days in the timeframe
SMA can be calculated for all four price levels Open, Close, Low, and High prices in a given timeframe. For example, closing prices of 5 days are 25, 28, 22, 23, and 29 then SMA for these five days are:
SMA= 25+28+22+23+29/5 = 25.2
Exponential Moving Average (EMA)
Exponential Moving Average (EMA) is another Moving Average indicator that reflects more accuracy and gives more weightage to recent data. It is more sensitive to the recent price of the stock as compared to the SMA which gives weightage to all the days equally. To calculate EMA, a three-step procedure is followed:
- Calculate SMA for a given time frame
- Calculate the multiplier for weighting the EMA through this formulae:
Multiplier = [2 / (Selected Time Period + 1)]
If the number of days in a selected time frame is 20 then the multiplier will be 2/(20+1) = 0.095
- Calculate current EMA by this formulae
Current EMA = [Closing Price – EMA (Previous Time Period)] x Multiplier + EMA (Previous Time Period)
Here the weightage given to recent data is higher for a longer time frame than for a shorter time frame. A multiplier of 9.5% is used for the recent price of a 10 days EMA while a multiplier of 4.75% is used for the price of 20 days EMA.
Simple Moving Average (SMA) v/s Exponential Moving Average (EMA)
There is one difference between these two moving averages and that is the sensitivity to price changes. EMA shows more sensitivity to the recent price changes while SMA gives equal weightage to all days under the time frame. So, it makes EMA more responsive to recent data than SMA.
Importance of moving average in Technical Analysis of Stock
Moving averages help to identify the trend by removing sharp, sudden fluctuations in a stock chart. These sudden movements in the stock price make it hard to identify a trend. So this tool calculates an average price for some days and compares it with averages of some past days so as to help a trader discover a broad trend in the market. This type of moving average is called a simple moving average (SMA). SMA takes the arithmetic mean of the price over a given period of time frame over the specified number of market days.
Limitations of Moving Averages
It must be kept in mind while calculating averages that moving averages are calculated for longer durations and not for a short duration of timeframe. Usually, these are calculated for more than five days, Ten days and one-month timeframes are more common.
Moving Average is helpful for the trader to identify trends in the highly volatile market when there is a sudden price movement in the stock price in a short span. But this works best for the longer duration as sensitivity reduces to the price change. The price of the stock contains various information within it which can be assessed through the NSE website by doing detailed research.