A moving average is a commonly used technical analysis tool used to smooth out price data and obtain an average value. In fast-moving markets, it can often be observed that the price of a stock is skyrocketing only to plummet some time later. These significant inconsistencies can potentially create false signals. Moving averages help to filter out the noise from such volatile price movements and act as trend-following indicators.

How can the Moving Average Method Help?

The direction of a moving average line assists the trader to understand which way the price of a financial instrument is moving. If the price of a financial instrument is above the moving average line, it is said to be on an uptrend.

On the flip side, if its price is under the moving average line, it’s on a downtrend.

If the moving average line of a stock doesn’t show any vertical movements for a long period of time, it indicates that the stock price is ranging and not trending. This is observed when a stock is traded between constant high and low prices for a certain period.

Moving averages also work as support and resistance indicators for traders. Most times, the price of stock finds support at the moving average line when the trend is up. Conversely, it meets with resistance at the line when the trend is down. Also known as a lagging indicator, a moving average line is based on previous closing prices. Hence, instead of giving a warning beforehand, it will only confirm a change in trend.

Primarily, when the price level of a stock rises above the moving average line, traders consider it as an indication to buy. And when the price falls below this line, traders contemplate it as a signal to sell.

Different Types of Moving Averages 

Primarily, there are three types of moving averages:

  • Simple moving average: 

A simple moving average or SMA can be a plot by calculating the average price of a stock over different time frames. These are mainly formed based on the closing prices.

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This can be cited better with a moving average example.

The first requirement for calculating simple moving averages is to find out the average prices of a given period and then dividing their sum by the total number of periods.

Let’s say Robin wants to calculate the simple moving average for XYZ Stock by considering the closing prices of the last 5 days.

The closing prices of the last 5 days are given by Rs. 24, Rs 25.50, Rs. 24.75, Rs 25.10 and Rs 24.60

The SMA can be computed as given below:

SMA = Rs. (24 + 25.50 + 24.75 +25.10 + 24.60) / 5

Therefore, SMA= Rs. 24.79

  • Weighted moving average: 

A weighted moving average (WMA) counters the various drawbacks of SMA. It puts more weight on recent data instead of the past. WMA follows the different price levels of stock more strictly than SMA.

  • Exponential moving average: 

Also referred to as EMA, this involves complex calculation. Similar to WMA, EMA puts more weight on the latest prices of a financial instrument. If a 100-day EMA and a 100-day SMA are plotted on the same chart, it can be seen that the former reacts faster than the latter. This happens due to greater emphasis on the recent prices.

Given below is a tabular representation showing how exponential and weighted moving averages are different from simple moving averages:

Point of Difference SMA EMA and WMA
Response to price changes SMA is slow to respond to price changes. EMA and WMA respond faster to changing prices.
Weight on recent periods It gives equal weight to all periods. These put more weight on recent periods.
Emphasis on traders’ actions  It doesn’t emphasise on traders’ actions. These emphasise on what the traders are doing at the moment.
Ability to reflect a quick shift in market sentiment.  SMAs are efficient in reflecting a quick shift in sentiment. These possess the ability to reflect shifts in market sentiment.

Disadvantages of Moving Averages

Although calculating moving average offers a quick and easy way to identify trends of financial instruments, they have the following disadvantages:

  1. Since each stock or commodity has its unique price history, no set rules can be implemented across all markets. Hence, a moving average cannot show the constant changes in their prices.
  2. The primary purpose of identifying a trend is to predict future values of the stock. But, if the security does not trend up or down, calculating moving averages will not be able to provide the traders with an opportunity to profit.
  3. Stocks often tend to show a cyclical behavioural pattern that cannot be interpreted by a moving average.
  4. Moving averages have the ability to be spread out over different time frames, but this can become quite tricky in specific situations.
  5. Similar to other technical analysis methods, moving averages do not consider the changes in primary factors that have an effect on the market price of a stock. Changes in the managerial structure of a company, changes in product demand of industry are also not taken into account.

Learning to trade using technical analysis like a moving average can be complicated for those uninitiated with the workings of the stock market. Now that you know what is moving average make sure to research as much as possible before adopting such trading techniques.