If you are just getting started with trading, you need to know about moving averages, commonly used in various trading markets, including the stock, Forex, and crypto markets.
Moving averages, also called running means or rolling averages, are one of the most basic and popular tools in technical analysis available for traders to help them make trading decisions. They are known for ease of use and unambiguous interpretation of the results. But they are lagging indicators as they rely on past data.
While running means don’t predict the future direction of the price, they help traders identify a trend beginning and end or potential price support and resistance. Traders use two common types of moving averages: the simple and exponential moving average. Let’s explore the difference between both.
Simple Moving Average: the basics
The SMA is a price trend indicator calculated by adding the closing prices of an asset over an X number of days and then dividing the sum by the number of days. This definition only includes the simple average or the arithmetic mean for a constant data set. For example, the simple average or arithmetic mean for the sequential values 1, 2, and 3 is 2 (1+2+3/3). Let’s now use an example for a changing or moving data set to capture the moving part of the simple moving average.
If the closing price of an asset on the first day is $1 and the next day is $2, and the following day is $3, then the 3-day SMA is 2 (1+2+3/ 3). If the fourth-day daily price close at $4, then the 3-day SMA becomes 3 (2+3+4/3). As a new daily closing price gets added, the oldest gets removed. The result of this process creates a simple moving average line, plotted on the price chart. An extreme price departure or arrival from and to the mean produces selling or buying signals for traders.
The SMA calculation method assigns an equal weight of importance to each closing price, helping to smooth out the price volatility. Traders can choose the different sequential periods to evaluate trends. The 20-day moving average is used for short-term price trends, while the 50 and 200 and used for medium and long terms trends respectively. Traders can customize the value settings in their trading software to suit their strategy and market conditions and combine them with others.
Exponential moving average
The next type of moving average we want to look at is the EMA, which is, you guessed it, a more complex type of moving average. The EMA is similar to the SMA, except it uses a weighted average, assigning more weight or importance to the most recent prices.
The formula looks like this:
EMA \u003d Rs * K + EMAv * (1 – K), where
K \u003d 2 / n – 1, n – averaging period
Pc – price today
EMAv – EMA value yesterday.
Traders don’t need to worry about calculations. Available trading tools and functions automatically plot the EMA of a given timeframe period on the chart. The EMA can be used for 50, 100, 147, and 200 days. Typical time frames used for short-term trading include 12 and 26 days. Winning trades using the moving averages require using a customized time frame. Resorting to the default or common values will not yield the best trading signals. Choosing custom values sets you apart from other traders and improves your winning trades.