What is a Moving Average?
In this section we will learn about moving averages. We will include definitions, calculations, technical analysis, uses and charting examples.
Moving Averages (commonly written as MA) are among the most popular and most useful techincal indicators. A Moving Average is a technical analysis used in order to show pricing trends by flattening out large fluctuations. Moving average data is used to create charts that show whether a price is trending up or down over time.
Definition
Moving Averages are mathematical calculations and results that are generally calculated by averaging a number of past data points. Each new day's (or week's or month's) numbers are added to the average and the oldest numbers are dropped; thus, the average "moves" over a specified time frame.
The purpose of Moving Averages is to smooth out the day to day (or time frame to time frame) values for a smooth flowing graphical representation of the general trend of the market prices. In general, the shorter the time frame used, the more volatile the prices will appear, so, for example, 20 day moving average lines tend to move up and down more than 200 day moving average lines.
There are four basic types of Moving Averages:
- Simple Moving Average (SMA)
- Exponential Moving Average (EMA)
- Smoothed Moving Average (SMMA)
- Linear-Weighted Moving Average (LWMA)
Major Uses of Moving Averages
Moving averages are commonly used to identify trends (sometimes known as momentum) and reversals as well as to set up support and resistance levels.
Moving averages can be used to identify whether a security is moving in an uptrend or a downtrend. As you can see in the graph below, a downward sloping moving average with the price below can be used to signal a downtrend. On the other hand, a moving average heading upward with the price is above it can indicate that the security is in an uptrend.
Moving average trend reversals can be indicated when the price moves through an important moving average. For example, when the price of a security that was in an uptrend drops below a moving average, as shown below at point 1, it is a sign that the uptrend may be reversing.
Moving Average Pairs
Another method of determining momentum is to look at the order of a pair of moving averages. When a short-term average is above a longer-term average, the trend is up. On the other hand, a long-term average above a shorter-term average signals a downward movement in the trend.
In the graph below, notice the distinctive indication of a downward trend when the 15 day SMA line is below the 30 day SMA line. Likewise the upward trend is indicated when the 15 day SMA line is above the 30 day SMA line.
Another indication of a possible trend reversal is when one moving average crosses through another. For example, as you can see above, if the 15 day moving average crosses above the 30 day moving average, it is a positive sign that the price will start to increase. And if the 15 day moving average crosses below the 30 day moving average, it indicates the price will decrease.
If the periods used in the calculation are relatively short, for example 15 and 30, this could signal a short-term trend reversal. On the other hand, when two averages with relatively long time frames cross over (50 and 200, for example), this is used to suggest a long-term shift in trend.
Moving Averages Support and Resistance
Moving Averages can also be used to identify support and resistance levels. Notice in the graph below, the red line is an SMA(150) plot, meaning a 150 day Simple Moving Average. At each of the arrows, the price approaches the SMA value, but never breaks through. Even as it is on a short term downward trend, the resistance of the 150 day price is evident and the overall long term trend is still upward. Near the end of the trend, the current price turns down and finally breaks through the resistance level of the 150 Day moving average. Once broken through, we can see that the price has continued a strong downward trend, confirming the reversal.
Moving averages help technical traders smooth out some of the fluctuations that are found in day-to-day price movements, giving traders a more clear view of the overall price trend. Moving averages are a powerful tool for analyzing trends in a security. They provide useful support and resistance levels and are very easy to use.
The more common time frames that are used when creating moving averages are the 200-day (a trading 'year'), 100-day (a half 'year'), 50-day (a quarter 'year'), 20-day (a month) and 10-day (two weeks).
