One of the most common problems faced while predicting the future market movements is the fact that prices do not rise or fall in a straight line. Almost always, upward and downward movements are accompanied by counter moves making it difficult for analysts to decipher the underlying trend of the market. It is in this context that moving averages help analysts to formulate charts in a much better way by smoothening the data.
Simple Moving Average, Exponential Moving Average and Weighted Moving Average are three ways of calculating moving averages. Of these, the Simple Moving Average technique is the most popular and widely used method, followed by the Exponential and the Weighted Average methods, respectively.
Calculation of Moving Averages:
Moving Averages may be calculated by doing simple arithmetic calculations on the price data of a scrip. Here, the price used for calculation may be the open, high, low or close price. Generally, the close price is found to be the most preferred for calculating moving averages. Again, moving averages may be calculated using data for different time zones such as the daily close, weekly close or monthly close. Here's a look at various types of moving averages and their calculation methods.
Simple Moving Averages
The calculation of a simple moving average involves the inclusion of the most recent price and the exclusion of the earliest price to depict the most recent trend. The exclusion and inclusion will depend upon the time horizon for which the moving average is calculated. Thus, the calculation of a simple moving average on a five-day horizon will mean that the average for the sixth day will be calculated by adding the sixth day's price and deducting the first day's price for the next point in the average series. This pattern is repeated for all subsequent days. Let us make it more clear with the following example:
Exponential Moving Averages:
An exponential moving average is calculated as per the following formula
Average = previous day average + (current price-previous day average)* factor
where factor = 2/n+1.
Here n is the number of days for which average is being calculated.
As the exponential average is not available for the first day, the close price of the day can be used for that day in place of the exponential average. For subsequent days, the calculation of the average will be as per the above formulae. Thus the calculation of an exponential moving average for a 5 day horizon will be as follows:
Weighted Moving Average
In this method of calculation, weights are given to the close price and the price is multiplied by the weights to arrive at a weighted price. This is divided by the sum of the weights to arrive at the average. Here, the latest price is given the maximum weightage. Thus, for a 5 day horizon, the current day's price will have a weight of 5, day 4 will have a weight of 4 and so on. The calculation can be depicted as follows:
Interpretation of Moving Averages
Analysts generally prefer to use simple moving averages for the purpose of getting buy and sell indicators from the market. A moving average helps the analysts in the following tasks:
1) It depicts the resistance and support levels.
2) It provides smoothness to historical data.
3) It represents the trend or direction for the period under consideration for the purpose of calculation of the moving average.
One of the primary functions of moving averages is to depict the support and resistance levels of a scrip. Thus, if the scrip price is above the moving average, this will act as a support for the scrip and the price can move upward from these levels.
If, however, the scrip is below the moving average, it will act as resistance levels and the scrip price will find it difficult to breach these levels. It is also seen that violation or penetration of a moving average is treated as the first sign of a trend reversal and needs to be studied carefully for the emergence of a new trend or counter move.
System of two moving averages:
It is often seen that a combination of two moving averages is used for the purpose of trend analysis and finding a pattern. Generally, one average is a short term average and other one is a long term average. Thus, a combination of these two averages together with the intersection thereof, if any, throws light on the likely patterns of price movements. Accordingly, you may plot a 5-day simple moving average along with a 20-day average to discern a pattern and trend reversals.
By using a combination of two moving averages, the buy and sell indicators are formed through the cross-over or intersection of the two average graphs. In the case of a falling market, the short-term moving average curve will be lower than the long-term moving average. When the scrip price tends to move up, the short-term curve goes above the long-term and the point of intersection is regarded as the trend reversal indicator and a buy signal to go long in the scrip.
The same logic is applicable in the case of rising markets, where the short-term average is above the long-term average. The point of intersection of the two averages may indicate a trend reversal and the possibility of a downward movement in prices. These concepts may be explained by way of the following diagrams for better understanding:
Analysts generally use a combination of the 5-day and 20-day moving averages or the 10-day and 40-day averages as also the 20-day and 40-day simple moving averages to infer information about future price movements and gauge the possibility of a trend reversal. In the case of exponential moving averages, generally, the 12-day and 48-day combination is used for plotting graphs.