Moving Averages are loved by both small traders with several hundred in their accounts and analysts at banks and hedge funds performing technical analysis. Why is that?
The idea behind them is that they eliminate noise and short-term distractions from the larger trend. That’s why they’re defined as a lagging indicator, following trends and showing their direction (rather than signaling changes in it).
There are two types of moving averages that focus on different aspects of the indicator. The first is the simple moving average (commonly abbreviated as SMA) and the second is the exponential moving average (EMA) which we will cover in one of our next articles.
The SMA is calculated as the average price over a set number of time periods. Traders usually take days as the most typical time period.
A 20-day SMA, the preferred one for day traders, would be calculated by taking the closing prices from the last 20 days (equal to four business weeks, roughly a month) and finding their average.
Let’s use that in an example. Say today is Monday, 29th of June and you want to find out what the 20-day moving average is. The first date of the month would be the 1st. 20 working days have passed since then. We would take the closing prices from the following dates: 1-5, 8-12, 15-19 and 22-26th of June and divide them by 20 – the number you get is the moving average.
Here comes the next part – to calculate the moving average for the next day – the 30th of June – you drop the closing price for the 1st of the month and substitute it with the closing price for the 29th. That’s how the calculation “moves” ahead.
For long-term traders the 200-day moving average is a staple and is equal to around a year of prices. It is perceived as a line that smooths out almost all distractions that could be a result of market manipulation, news events that contradict the trend, etc. Price moves above or below it are considered news events in their own right and are used as buy or sell signals.
Another way to use them is when moving averages covering different periods cross each other. An example of a bullish signal when moving averages cross is when the 20-day moving average crosses above the 200-day one. The interpretation here is that a short-term trend is coinciding with a long-term one and that confirms the general direction.