No matter if you are new to investing or have been investing for a long time, it is important to know the terms used in the investing world. If you are a beginner, it is normal to have questions such as how to invest, when to invest, or where to invest.
However, an important term and an analysis tool used by investors that you should be familiar with is the moving average. To make it short, it is a technical analysis stock indicator that calculates the moving average stock price for any period of time.
Investors can decide what time period they want to see the MA for, no matter if it is 10 months or 10 days. The way it works is that when checking the moving average of a stock price for any time period, any short-term changes in the price of that stock during that time period are alleviated.
What is The Moving Average And Some Examples
Moving averages are used to identify a sort of trend line for a certain stock price for any time frame. It is a lagging indicator for past prices. What is lagging? Well, lagging, to keep it short, verifies trends and the changes that happen in trends and prices in stocks.
(Lagging or trend line example, source: dnbcmarkets)
In this graph, we have an example of lagging. The blue line in between the price changes in the graph presents the lag, or the trend line. It is a good way for investors to see the moving average and price changes of a certain stock price for a certain time frame.
Lag depends on the period chosen. So, if we decide to look at the moving average for the last 6 months, the lag will be much greater than it would be for a shorter period like one week.
Usually, investors and traders tend to look at the moving average of 200-day periods or 50-day time periods. For investors, the trend line in these time frames is important for trading signals.
Different investors look at different trend lines. What does that mean? For example, an investor that is mainly investing in short-term investments will most likely look at shorter time frames for trend lines and moving averages. On the other hand, long-term investors will generally opt for longer time frames.
Examples of Moving Averages
In this case, we will use an example of a Simple Moving Average, which is a type of moving average, but we will get to that later. Let us take the security of 20 days as an example:
- First 10 days: 46, 48, 49, 50, 51, 49, 46, 42, 48, 49.
- Second 10 days: 50, 52, 55, 56, 57, 53, 50, 48, 47, 48.
So in an SMA, in order to understand and calculate the moving average, it will take the first 10 days and average that. After that, once the 11th day comes, the closest data point will give the SMA the data and it will use that to calculate the moving average again, and so on until the 20th day.
What Are the Types of Moving Averages?
We talked about what moving averages are and we took an example. But to fully understand moving averages, we have to understand their two types. The two types that we are going to talk about today are the Simple Moving Average (SMA) and the Exponential Moving Average (EMA).
Simple Moving Average
The simple moving average is pretty easy to understand. It is a classic way of finding the average of multiple things. What SMAs do is that they take the number of averages in different time frames, add them together, and divide that by the number of prices used.
Okay let us portray it in a formula for easier understanding:
SMA = A1+A2 + A3 + … + Ann
Where:
- A: Average price of a certain time frame (e.g. one day).
- n: Number of prices used in the equation.
Exponential Moving Average
The Exponential Moving Average needs the SMA first in order to be calculated. The difference between the two is that the EMA usually has more weight or gives more weight to the recent prices.
After calculating the Simple Moving Average for a certain time frame then you can calculate the Exponential Moving Average for that time frame with the multiplier of the weight gain. The formula needed for this is something like: [ 2 / ( chosen time frame + 1 ) ].
Is EMA Better Than SMA?
Because EMA puts more weight on recent prices that also makes it possible for EMA to respond more quickly to new price changes. Different from SMA, EMA has higher value when prices are high and lower value when prices are low meaning it reacts faster.
This reason and some others make the Exponential Moving Average a better choice for investors. It also is a better alternative for traders and they choose EMA more often than SMA.
How To Use MAs For Investing?
Before we get into this section it is good to discuss on why to use a moving average. Moving averages remove noise from a price chart allowing you to see the trend line of a certain chart for any time frame.
This does not only allow investors to see the prices and the trend line (or lag), but it also helps to predict better on future prices of that stock. We know that predicting isn’t always right and not always can anyone predict something correctly. But MAs make it possible to have a better idea for your predictions.
Moving Averages and Trading Strategies
Strategies are commonly used in trading. It is a way for investors to see if lag in a price chart of a stock has a pattern to it. However, these strategies are not always correct though they are mainly used because they happen commonly so it is expected to happen.
Let us take an example. Crossover is a common strategy used in trading. Investors notice when the recent prices of a certain stock have gone way below the trend line it is common for that price to shoot up.
(Here is a visual representation of a crossover in stock prices, source: Investopedia)
As we can see in the chart above, the price of the stock went down below the trend line, and then it shoots up again. The golden cross is called the touching point of a 50-day and 100-day moving average after the crossover.
Another strategy with moving averages in trading is what is called the Death Cross. Different from the Golden cross the death cross happens when the 50-day period Simple Moving Average falls below the 200-day one.
This for investors is a sign that the price will continue to fall and it will have a much lower price. This makes it easier for investors to know when to invest and when not to. Although as we mentioned it is not always correct.
Disadvantages of Moving Averages
What are some disadvantages that Moving Averages bring? Well in this section we are going to talk about just that, having talked about what they are and how to use them up until now. Moving averages can be random. Well, the main reason stands because they are not very predictable, to begin with.
Depending on the market, moving averages tend to have ups and downs in uses and respect for their work. Sometimes they are deemed useful by the market and at other times they are not.
When a price chart or a position of a stock is choppy and not very trendy, moving averages tend to not work very well. This makes the MAs create trend signals for no reason leading to a lot of losses for investors. However, in trendy conditions, MAs work very well and are used a lot.
Takeaways
- No matter if you are new to investing or have been investing for a long time it is important to know the terms used in the investing world.
- Investors can decide what time period they want to see the MA no matter if it is 10 months or 10 days.
- Moving averages are used to identify a sort of trend line for a certain stock price for any time frame.
- Usually, investors and traders tend to look at the moving average of 200-day periods or 50-day periods.
- The two types that we are going to talk about today are the Simple Moving Average (SMA), and the Exponential Moving Average (EMA).
- The difference between SMA and EMA is that the EMA usually has more weight or gives more weight to the recent prices.
- Strategies are commonly used in trading.
- Different from the Golden cross the death cross happens when the 50-day period Simple Moving Average falls below the 200-day one.
- Depending on the market, moving averages tend to have ups and downs in uses and respect for their work.
