Technical Analysis - Moving Average

A moving average is a method, tools used to analyze a set of data points by creating a set of averaged data. A moving average is represented as a line (set of data points) and is commonly used with time series. In technical analysis moving average is the basic and most used tools which is used to smooth out price (volume, advance-decline data or any other stock's data ) short-term fluctuations and spikes and highlight longer-term trends.

There are two types of the moving averages in technical analysis: simple moving average (SMA) and exponential moving average (EMA). In some trading system could be used displaced SMA or displaced EMA which are the same moving averages with the only difference that they are displaced on the certain number of bars to the left or to the right.

The formula for simple moving average is

SMA(n) = (A1+A2+...+An) / n

Where A1-An could be close value of the price bars and is the number of bars. In some cases simplified formula could used to calculate simple moving average:

SMA(n) = Previous SMA - Previous Close / n + Current Close / n

An exponential moving average (in some cases called as weighted moving average) could be calculated by following formula:

EMA(n) = 2 / (1 + n) * (Close - Previous EMA) + Previous EMA

By itself, a moving average applied to the stock's price, stock's volume or any other stock's parameter does not predict trend changes and it does not tell where the price of the stock will be in the future. Rather, the moving averages reveal the current trend by removing short-term spikes and movements from the general trend. If a moving average applied to stock's price moves up technical analysis states that the current stock's trend is Bullish (up-trend). If a moving average applied to a stock's price declines technical analysis states that the current stock's sentiment and trend is Bearish (down-trend). In similar way, rising moving average applied to the stock's volume would indicate increase in the trading activity, while decline of moving average applied to the stock's volume would indicate halting in trading activity.

Even moving averages do not predict trend changes by themselves, they are used as a combination of shorter-term and longer-term averages to define trends for different periods, compare them and assume possible changes and possible coming trend reversals. An example of a simple technical analysis could be a comparison of two moving averages on an assumption that shorter-term moving average reveals changes in a trend faster than the longer-term moving average, yet the longer-term moving average is more conservative and it reacts on stronger trends:

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  If shorter-term moving average defines the current stock's short-term trend as an up-trend and longer-term moving average defines longer-term trend as an up-trend then a technical analyst may assume that the odds are higher that the longer term up-trend will remain unchanged in the near future.
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  If a shorter-term moving average defines the current stock's short-term trend as an up-trend however a longer-term moving average defines longer-term trend as a down-trend then a technical analyst may say that there is exists a possibility of changes in the longer-term trend from the down-trend into an up-trend in the near future if the shorter-term moving average will continue rising.

This is a simple example of using main characteristics of the moving averages to predict trend changes and which are used in the MACD, TRIX and other more advance technical indicators.

The other way of using moving averages is to apply them to already existing technical indicators to remove fluctuation and reduce the number of fake buy/sell signals. Thus, moving averages are applied to volume to reveal strong volume surges (abnormal trading activity), they are applied to advance/decline data to see where the main interest (sentiment) of traders is located in advancing or in declining stocks, in volatility indicators moving averages are used to define period of high and low volatility, etc. Yet, by applying moving averages a trader (technical analyst) should always remember that while moving averages smooth out data and remove fluctuation, they create a lag (delay) in the generating signal. Thus, increase of bar period of moving average may remove the majority of fake trading signal from the analysis and trading system, yet, it may delay the generating of the signals to the moment when it could be too late to open/close a trade. The art is in selecting a bar period of moving averages that would filter the main fake signals, yet would keep the lag in reasonable time frame.

The third way of using moving averages in technical analysis is building signal lines. In many technical indicators and trading systems a trading signal is generated when an indicator reverses from its highest or its lowest levels. In some technical indicators (RSI, Stochastics, etc) a constant signal level could be used. However, with many other indicators (MACD, the same Stochastics and other various oscillators) a moving average applied to the indicator could be used as a signal line and buy/sell signals could be generated on the crossovers of an indicator and its signal line.