MOVING AVERAGE

One of the most common and familiar trend-following indicators is the moving averages. They smooth a data series and make it easier to spot trends, something that is especially helpful in volatile markets. They also form the building blocks for many other technical indicators and overlays.The two most popular types of moving averages are the Simple Moving Average (SMA) and
the Exponential Moving Average (EMA). They are described in more detail below.

Simple moving average (SMA)

A simple moving average is formed by computing the average (mean) price of a security over a specified number of periods. It places equal value on every price for the time span selected. While it is possible to create moving averages from the Open, the High, and the Low data points, most moving averages are created using the closing price. For example: a 5-day simple moving average is calculated by adding the closing prices for the last 5 days and dividing the total by 5.

10+11+12+13+14=60/5=12

Exponential moving average (EMA)

Exponential moving average also called as exponentially weighted moving average is calculated by applying more weight to recent prices relative to older prices. In order to reduce the lag in simple moving averages, technicians often use exponential moving averages. The weighting applied to the most recent price depends on the specified period of the moving average.

The shorter the EMA’s period, weight is applied to the most recent price. For example: a 10-period exponential moving average weighs the most recent price 18.18% while a 20-period EMA weighs the most recent price 9.52%. As we’ll see, the calculating and 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. Here’s the calculation formula.

EMA (current) = ((Price (current) - EMA (prev)) x (Multiplier) + EMA (prev)

For example, a 10-period EMA’s Multiplier is calculated like this.

2 \ (time period+1) = 2 \10+1 = .1818

(18.18%)

This means that a 10-period EMA is equivalent to an 18.18% EMA.

Moving average crossover

A price break upwards through an MA is generally a buy signal, and a price break downwards through an MA is generally a sell signal. As we have seen, the longer the time span or period covered by an MA, the greater the signifi cance of a crossover signal. If the MA is fl at or has already changed direction, its violation is fairly conclusive proof that the previous trend has reversed.

False signals can be avoided by using a filtering mechanism. Many traders, for example, recommend waiting for one period - that is one day for daily data and one week for weekly data. Whenever possible try to use a combination of signals. MA crossovers that take place at the same time as trend line violations or price pattern signals often provide strong confirmation.

Moving averages are helpful in keeping you in line with the price trend by providing buy signals shortly after the market bottoms out and sell signals shortly after it tops, rather than trying to catch the exact bottom or top. There are three ways to identify the trend with moving averages: direction, location and crossovers.

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