16 July 2020
Predicting trends in the stock market is not as simple as it seems. Even though it is a complicated process, it does not mean that it can’t be done. There are some research tools to make your technical analysis easier. You may have heard of moving averages (MA) before. Not to worry if you haven’t heard of them! In this article, we will tell you what they are and how they work.
What Are Moving Averages?
A moving average (MA) is a stock indicator. This is used as a technical analysis tool. Its main purpose is to check price movements over a specified period. Furthermore, it is used to smooth out the closing prices of the market. This can easily be done with an updated average price. Moving averages are also used to identify the trend direction. Moving averages is not a traders-only tool – it is also used by long-term investors. There are around four types of moving averages. But there are two of them that stand out. Those are the simple moving average (SMA) and the exponential moving average (EMA). The simple moving average does not give any weighting to the averages in the data set. The exponential moving average, on the other hand, gives more weighting to current prices.
How Do You Calculate A Moving Average?
As it was mentioned above, there are two common moving averages. On the one hand, the simple moving average is calculated by taking the average of all the data points in the series. After that, it divides them by the number of points. Yet, the main problem of the SMA is that — as we already mentioned — all the data points will have equal weighting. This may distort the true reflection of the current market trend. Each of these indicators has a formula. The formula for SMA is the following one:
SMA = A1 + A2 + … An / n
Each “A” represents one of the data points. The “n” is the number of time periods.
On the other hand, the exponential moving average was created to solve this problem. For that reason, it gives more weight to the most recent prices of the market. In other words, the exponential moving average is closer to the current trends in the market. This is particularly useful to determine the asset trend direction.
To calculate the EMA, we first have to calculate the SMA for a particular period. Then, we have to calculate the multiplier for weighing the EMA using a specific formula. Last, we use the smoothing factor combined with the previous EMA to get to the current value. The EMA mathematic formula is :
EMA = ( Vt X (S/1+d) + EMAy X [1- (S/1+d)] )
Here, “Vt” is today’s value, “s” means smoothing, and “d” the number of days. There are many possible choices for the smoothing factor, the most common choice is 2. Thus, to calculate the multiplier for smoothing (weighting), we must apply the formula: [2 ÷ (number of observations + 1)]. For example, for a 10-day moving average, the multiplier would be [2/(10+1)] = 0.01818. There is also another way to see and understand the formula to calculate the current EMA. That is by looking at it as “closing price x multiplier + EMA (previous day) x (1-multiplier).”
Nonetheless, one can use these moving averages for three different things:
- To determine the direction of the trend.
- To determine support and resistance levels.
- Using many moving averages for long and short-term market trends.
In summary, the main purposes of moving averages are eliminating short-term fluctuations. This can help us determine different trends in the market. Many traders and investors use more than one moving average at a time. This is because it gives them a better view of the status of an asset in the market.
Finally, they are also used as a way to determine market entries. They also help us identify support and resistance levels. Since it is a customizable indicator, it gives a lot of power to the trader or investor. He or she can choose the timeframe that suits their trading style. You can also choose how to use them. Once you understand them, they can help you to make bigger profits.