Charting University » Moving Averages
Moving Average calculations are one of the simplest and most popular charting tools available to the technical analyst. They smooth a given series of daily closing numbers into averages, making it easier to spot trends in a stock or index. This can be especially helpful in volatile markets. Moving averages are also often the bases from which other technical indicators and alerts are built from.
There are extensive writings on this technical theory, however, the most widely used periods are 18, 20, 40, 50, 100, and 200 day averages. The shorter the term of days is obviously represented with a lower number - and the faster the line will react to change.
Swing Traders generally use the 50, 100, and 200 day averages to view longer term trends. The proper number to use is the one that best suits your own trading habits.
The two most popular types of moving averages are the Simple Moving Average (SMA) and the Exponential Moving Average (EMA).
Simple Moving Averages are formed by calculating the average (mean) price of a security over a specified number of days/periods. Most moving averages are created using closing price averages, however, it can also be done by using the High, Low, and Open points for a period as well. We will only use the day's end Closing Price Averages for this article.
Below is a 50-day simple moving average line that acted as resistance over many months in 2008.
Let's start by discussing how these lines are figured. An 8-day simple moving average (8/SMA) is calculated by adding the closing prices for the last 8 days and then dividing the total by 8.
Here is an example, with each number representing the closing price on each day:
$7.00 (day 1) + $8.00 (day 2) + $9.00 (day 3) + 10.00 (day 4) + $11.00 (day 5) + $12.00 (day 6) + $13.00 (day 7) + $14.00 (day 8) = $84.00 total sum of all days
($84.00 / 8 Days) = $10.50 is the simple average of this example.
To make this easy to use, the calculation is set by your charting software and then joined to form a smooth curving line, the moving average line.
This line continually changes like a snake's direction because of each day's changing closing price. If the next closing price in the average is $15.00, then this new period would be added and the oldest day, which is $7.00, would be eliminated. The new 8-day simple moving average would be calculated as follows:
$8.00 + $9.00 + 10.00 + $11.00 + $12.00 + $13.00 + $14.00 + $15.00 = $92.00 total
($92.00 / 8) = $11.50 average
Exponential Moving Averages are a weighted outcome, formed by calculating the average (mean) price of a security over a specified number of days.
The EMA calculation reduces the lag by applying more weight to recent prices relative to older prices. The weighting applied to the most recent price depends on the specified period of the moving average. The shorter the EMA's period, the more weight that will be applied to the most recent price.
For example: a 10-period exponential moving average weighs the most recent price at 18.18%, while a 20-period EMA weighs the most recent price at 9.52%. Calculating the EMA is much harder than calculating an SMA. The important thing to remember is that the exponential moving average puts more weight on recent prices. As such, it will react quicker to recent price changes than a simple moving average.
Simple (SMA) or Exponential (EMA) - which to use?
The moving average that you choose to use will depend on your trading and investing style and preferences. The simple moving average obviously has a lag, but the exponential moving average may be prone to quicker breaks that knock you out of a trade too quickly - or in too quickly.
Some traders prefer to use exponential moving averages for shorter time periods to capture earlier changes. Others, like me, prefer simple moving averages over long time periods to identify long-term trend changes.
mentioned above, the proper number to use is the one that best suits your own trading habits. You may find that a 50-day SMA might work great for identifying support levels in AAPL, but a 100-day EMA may work better for the Dow Transports.
Moving average type and length of time will depend greatly on the individual security and how it has reacted in the past. You may find the 200/SMA, for example, so far away from the current price that it is useless to your needs. Experiment with other timings while you are charting and you will soon find stocks that clearly follow the lines over time.
Other Ways to Effectively Use Moving Averages
The Bullish Cross occurs when a shorter-term moving average crosses above a longer-term moving average, showing short-term bullishness and a possible beginning to a run. In the XLNX chart above, the 50/SMA is meeting the 200/SMA and will likely cross above it. This chart would alert long then.
The Bearish Cross occurs when a shorter-term moving average crosses below a longer-term moving average, showing short-term bearishness and a possible beginning or confirmation to a downtrend. In the IBM chart below, the 20/SMA crossed below the 50/SMA. The result was a drop from the $120 area into the $70 line and Price never re-crossed above the longer term moving average, in this case the 50/SMA.
In conjunction with other technical factors these lines can be very helpful. Notice the basic sideways action here of the DJIA, then the Bullish Hammer suggested a base, followed by the Bullish Cross. The 1250+ Buy-signal ran as high as 1424 before re-crossing.
One other use of many is called a Moving Average Ribbon. This is built by using 3-10 different MA lines on the same chart, all fairly close together in timing. The theory is that as the ribbon (multiple MA lines) turns one way or the other, it suggests direction.
There is quite a lot that can be done with Moving Averages and they should be another tool in your arsenal.