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What is Moving Average?

 

Moving averages are an indicator calculated by averaging the price of a financial instrument over a certain period of time. Moving averages are often used for technical analysis. While the moving average can give clues about price trends, it can also help identify points of support and resistance.

 

How to Use Moving Average in Technical Analysis?

 

The moving average is inherently a lagging indicator. In other words, it is the result of price fluctuations. Therefore, it is not used to make predictions about future price movements, but to validate the analyses on the current state of the financial instrument.

Moving averages also form the basis of other popular technical analysis indicators such as Bollinger Bands and MACD. In particular, the 50-day moving average, 200-day moving average and RSI indicator analyses are among the most commonly used methods to perform technical analyses of trading instruments.

 

How to Read a Moving Average Chart?

 

Day-to-day calculation is done by using the moving average formula. Each day's closing price coincides with a point on the chart. When the dots are connected, the emerging trend line turns into a chart that provides insights for investors.

The closing price of each new day naturally has an impact on moving average trends. When there is a strong price action that breaks the trend line, it means a strong trading signal for traders.

 

The rest of our article deals with;

  • What is Simple Moving Average (SMA)?
  • What is Exponential Moving Average (EMA)?
  • What is Weighted Moving Average (WMA)?


What are Different Types of Moving Averages?

The most common moving averages for technical analyses are;

  • Simple Moving Average (SMA),
  • Exponential Moving Average (EMA),
  • Weighted Moving Average (WMA).

 

Simple Moving Average (SMA)

 

The simple moving average (SMA) is the most commonly used type of moving average. It is calculated by averaging the daily closing prices of a financial product within a fixed period of time. E.g; 7-day simple moving average = It is obtained by adding the closing prices of the product over 7 days and dividing them by 7.

To make it clearer with an example;

Let’s assume the license code of the financial instrument is XYZUSD. Let the closing prices of XYZUSD in the last 7 days be as follows:

1st day closing price: 3.50
2nd day closing price: 3.70
3rd day closing price: 3.75
4th day closing price: 4.25
5th day closing price:  5.30
6th day closing price: 4.80
7th day closing price: 5.20
 

Since the 7-day simple moving average will be = (sum of 7-day closing prices / 7), 30.5/7= 4.36.

The simple moving average is more suitable for short-term market analyses. As the base period gets longer, the simple moving average will be less likely to make a meaningful contribution to your analyses. In fact, using the simple moving average for a long-term technical analysis can generate erroneous results.

 

Weighted Moving Average (WMA)

 

The weighted moving average gives more importance to the figures of the most recent days while averaging the closing prices of a financial instrument within a time frame. Because with simple moving average, the value of each day is equal. According to many analysts, this method is way too cursory. It is a different story with weighted moving average calculations. Because it is argued that old price movements are less important than recent price movements.

Let’s give another example;

 

Example of a Weighted Moving Average (WMA):

Let’s assume once again our financial instrument is XYZUSD. The table below shows the 5-day closing prices of XYZUSD.

 

Day

 Closing Price

Weight

 

1

$91

1/15

 

2

$90

2/15

 

3

$89

3/15

 

4

$88

4/15

 

5

$90

5/15

 

 

Let's remind you of the weighted moving average (WMA) formula:

n = period

 

Let's revise the table according to the price table and weighted moving average formula and add a weighted average price column:

Day

Closing Price

Weight

Weighted Average

1

$91

1/15

$6.07

2

$90

2/15

$12

3

$89

3/15

$17.80

4

$88

4/15

$23.47

5

$90

5/15

$30

 

The weighted moving average of XYZUSD in this case is $30 + $23.47 + $17.80 + $12 + $6.07 = $89.34.

 

Exponential Moving Average (EMA)

 

Exponential Moving Average (EMA) is a technical indicator that shows how the price of a security has changed over a period of time. Basically, price movements within a specified period are averaged, but more weight is given to recent price movements when doing the calculation. Exponential Moving Average (EMA) works like Weighted Moving Average (WMA), but unlike it, it also averages the price figures from past days rather than attaching little importance to them. So, a 100-day exponential moving average would use all historical data, not just the last 100 days. This makes it a more valid analysis method.

 

How to Calculate Exponential Moving Average (EMA)? What is the Exponential Moving Average (EMA) Formula?

 

EMA = K x (Current Price – Previous EMA) + Next EMA

K (Weight factor) = 2/(number of days+1)

Note:
When calculating the first EMA (since the previous EMA does not exist), the average of the prices, that is, the simple moving average, is taken. For more recent EMAs, calculation is done according to the formula.

Weight factor for 21-Day EMA:
K21 = 2/(21+1) = 0.090 = 9%

Weight factor for 100-Day EMA
K100 = 2/(1100+1) = 0.019 = 1.9%
 

As can be inferred from the examples, the 21-day EMA gives 9.0% weight to the most recent price, while the 100-day EMA only gives it a merely 1.9% weight. Therefore, EMAs calculated for shorter periods are more sensitive to price movements in the markets than those calculated for longer periods.

The exponential moving average (EMA) is also analyzed and interpreted like a simple moving average. However, when analyzing trends, Exponential moving average (EMA) can provide a more precise analysis. While the EMA has an incrementally ascending trend, it can be interpreted as a buy signal if the price of the instrument is close to the trend line of the EMA. If the price of the instrument is above the EMA while the EMA is in a downtrend, this can be interpreted as a sell signal.

Moving averages can help you trade with overall trends, but no technical analysis is 100% accurate. Moving averages also help you identify points of support and resistance. For example, exponential moving average (EMA) with an upward trend can act as buffer for price drops. In an opposite scenario, when there is a falling EMA and there is an upward price movement on the relevant instrument, the EMA trend line can be expected to function as a point of “resistance”.

Moving averages, used extensively for technical analyses, also act as reference to other trading analysis methods. For example, the intersection of 50-day and 200-day moving average is an important technical analysis indicator. When the short-term moving average crosses the long-term moving average upwards, it is called the Golden Cross. In technical analysis, Golden Cross is interpreted as a continuation of the rise of prices. Conversely, the short-term moving average crosses the long-term moving average downwards. This is called the "death cross". The realization of the Death Cross is interpreted as a falling trend in prices.

We would like to remind all our investors that no technical analysis signal can give a precise projection about the future trend of prices. Therefore, each investor should set his own risk threshold.