What Do You Mean By Moving Averages indicator In Technical Analysis?

What Do You Mean By Moving Averages indicator In Technical Analysis?

Moving Averages indicator

INTRODUCTION

Moving averages indicator are the most common & simple to use tool for technical analysis. Moving averages indicator do not predict the price direction but rather define the current direction with a lag. That’s why they are called ‘’lagging’’ indicators. Moving averages indicators work well when prices are in trend, and they can give a false signal when prices are not trending.

For Short term Trend one canconsidered11 & 21-day moving averages, for the Medium/Intermediate term 21 to 100 days is generally considered a good measure. Finally, any moving average indicators that uses 100 days or more, can be considered measuring long-term momentum. The shorter the MA the more sensitive the signal.

Types of Moving Average indicator :

The most popular types of moving averages are the Simple Moving Average (SMA) and the Exponential Moving Average (EMA). These moving averages indicators can be used to spot the direction of the trend or to identify potential support and resistance levels.

Simple Moving Average indicators (SMA)

A simple moving average indicators is computed by taking the average price of a security over a certain number of periods. While it is also possible to calculate moving averages from the open, the high, and the low data points but most moving averages are constructed using the closing price. For example, a 5-day SMA is calculated by adding the closing price for the last 5 days and dividing the total by 5.

Daily closing prices 5, 6, 7, 8, 9 & 10

First day of 5-day SMA: (5+6+7+8+9)/5 =7

The second day of 5-day SMA: (6+7+8+9+10)/5 =8

Whether you choose a 21-day average or a 52-week average the calculation is the same instead of adding five days you add 21-day or 52 weeks and divide by the same, respectively.

Exponential Moving Average indicators

The exponential moving average indicators is used to reduce lag in simple moving averages. It reduces the lag by applying more weight to recent prices relative to older prices, hence it will react immediately to recent price change than an SMA For example a 5-period exponential moving average weighs the most recent price 33.33%

The formula for an exponential moving average is

EMA= (Closing price –EMA (previous day)) * (Multiplier) + EMA (previous day)

A 5-period EMA Multiplier is calculated below:

2/(Time period+1)= 2/(5+1) = 33.33%

Role Of Moving Average In Determining Market Trends

Moving average can also be used to determine the trends, If the moving average is rising then the trend is considered up and if the moving average is falling, the trend is considered down. It also helps in identifying support & resistance.

As seen in the following chart of Reliance Capital, 100-day medium-term moving average which was previously acting as resistance level is now acting as a strong support. The stock also broke the 20-day short-term moving average on several occasions but was able to sustain above 100 days moving average, which indicates the medium-term trend of the stock is very strong. With the combination of two moving averages, the Investor and investor/trader can make their buy or sell decisions depending on the time horizon to hold.

Role of Moving Averages in Technical Analysis of the Market

Moving Average Crossover

Moving average crossover is a popular strategy for defining entry & exit points.

When the shorter moving average crosses above the long-term moving average, it shows the trend is shifting up and creates a buy signal. This is called “Golden Cross”.

When a shorter moving average crosses below the long-term moving average, it shows the trend is shifting down and creates a sell signal. This is called ‘Death Cross.

Moving Average Crossovers – Technical Analysis

Summary

Moving average helps to identify the trend and keeps you on the right side of the trend, one should not solely rely on the moving average to enter at the bottom and exit at the top rather it should be used in conjunction with other technical tools that complement them. Moving averages also helps in level of security.