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Did you know that traders who use charts to analyse price movements without using technical indicators are called “chartists”? Charts have a story to tell, but to understand the language of their narration, you need technical indicators. These interpret the story in the form of easy-to-understand signals that help you identify entry and exit opportunities.
One of the most used indicators is Moving Average. The reason for its popularity is that it smooths out the price data, removing the impact of short-term and random fluctuations, to help identify broader trends. Moving Average is popular among beginners and seasoned traders alike. It’s simple for beginners to understand, while pairing well with most other technical indicators for experienced traders to prepare their favourite trading toolkit.
Did you know?
The indicator is called Moving Average because it keeps recalculating and updating the average price as the price of an asset fluctuates. So, it’s a lagging indicator, as it trails the asset’s price action to highlight the direction of the trend that forms over a specified timeframe.
This is a straightforward indicator that sums the latest price movements and divides the total by the number of time periods.
How to calculate: SMA = (AP1 + AP2 + AP3 ………. APn) / n
Here, AP is the average price in the period n, and n is the number of periods.
While traders can use SMAs for different types of prices, like highs, lows, open, and close, usually the closing price is used. This technical indicator is typically used to identify support and resistance levels. So, the 20-day SMA refers to the average of closing prices over the past 20 trading days.
This gives a higher weight to the latest prices, as these play a more meaningful role in determining future price movements than historical data points. SMA gives weightage to all price fluctuations in a chosen timeframe.
How to calculate: First, create a list of the closing prices of the asset over the chosen time period. Then determine the weights of each of these by dividing the day number by the sum of the days. For instance, in the table below, the sum of the days is 1+2+3….+10, which is 55. Then multiply the weight with the closing price of the asset.
| Day | Weight | Closing Price of XYZ Stock | Weighted Average |
| February 1 | 1/55 | $100 | 1.82 |
| February 2 | 2/55 | $102 | 3.71 |
| February 3 | 3/55 | $99 | 5.40 |
| February 4 | 4/55 | $98 | 7.13 |
| February 5 | 5/55 | $99 | 9.00 |
| February 6 | 6/55 | $97 | 10.58 |
| February 7 | 7/55 | $98 | 12.47 |
| February 8 | 8/55 | $99 | 14.40 |
| February 9 | 9/55 | $100 | 16.36 |
| February 10 | 10/55 | $101 | 18.36 |
The WMA is obtained by adding up the weighted averages. In the above, the WMA is 1.82 + 3.71 + 5.40… + 18.36 = $99.24.
This also assigns a higher weight to the most recent prices, but the gap between the weights is not consistent. The rate of decrease between one price and its preceding price is exponential.
How to calculate: First, calculate the multiplier for weighting the EMA with the formula:
Multiplier = [2 / (Selected Period + 1)]
So, for a 10-day EMA, the multiplier will be [2 / (10+1)] = 0.1818, while for a 20-day EMA, the multiplier will be [2 / (20+1)] = 0.0952.
Then, the current EMA is calculated with the formula:
EMA = [Closing Price – EMA (Previous Period)] x Multiplier + EMA (Previous Period)
This uses a double-smoothed EMA, giving even more weightage to the most recent prices. It is said to greatly reduce the lag results that crop up when using the EMA and is most frequently used by scalpers or when the market is highly volatile.
How to calculate: First, the EMA is calculated. Then, an EMA calculation is done again, using the result of the first EMA as a function in the formula.
DEMA = [2 ∗ EMA(n)] – [EMA * EMA(n)]
This uses a double smoothed SMA, which means the price data is averaged twice. This indicator is often used to identify changes in the direction of the trend.
How to calculate: TMA = (SMA1 + SMA2 + SMA3 + . . . . . . + SMAn) / n
The good news is that you don’t need to make these complex calculations. Moving Average indicators can be applied to MT4/MT5 charts with a simple drag and drop.
Interpreting Moving Averages
Irrespective of the type of moving averages:
When using moving averages with different time periods:
A price crossover is said to occur when the asset price crosses above or below a moving average line, signalling a potential change in trend.
This involves plotting three different MAs with different time periods, which helps eliminate false signals. The first two MA lines are used to determine whether a deviation of the price from the trend is indicative of a reversal of the trend or simply a momentary fluctuation. The third MA line is used to confirm or deny the signals.
Apart from these, the Moving Average Convergence Divergence (MACD) is another popular technical indicator. This considers the difference between a short-term EMA and a longer-time one, typically calculated using the asset’s closing prices. The crossover of the MACD with the signal lines indicates possible entry and exit points.
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