Tuesday, Feb 5 2019 8:47AM

Do you remember the concept of averages you learnt in school? Well, that same mathematical concept is a popular and powerful tool used by traders in the stock market.

Stocks experience a lot of volatility in the market. As a result, the price of a stock could get very high. But after some time, the price could suddenly nosedive. This kind of volatility can make it difficult for traders to understand which way the stock is moving.

Moving averages come in handy in such situations.

What are moving averages?

Moving Average (MA) is a commonly used indicator in technical analysis. This tool filters out the ‘noise’ and calculates the average value of a stock price over a specific period.

The time period can range anywhere between five minutes to even 200 days. It all depends on what information the trader wants.

Moving averages are extremely useful for traders to identify trends in the movement of a stock. For example, if the prices are above the moving average, it indicates that the stock is in an uptrend.

On the other hand, prices below the moving average line indicate a downtrend.

And when the moving average line breaks through the stock price, it indicates a reversal in the trend.

So, if there is a trend reversal and the stock starts to move upwards, the trader takes it as an indication to buy the stock and vice versa.

A moving average is known as a lagging indicator because it is based purely on the past prices of the stock. This means it will not be able to warn the trader about the changes in future stock prices. It can only help to confirm when a change takes place in the trend.

How is moving average calculated?

The formula for moving average is:

MA = (SP1+SP2+SP3+SP4+SP5)/5

Here, SP = Stock Price.

Let’s take the example of stock X.

In the past five trading days, the closing prices of the stock are as follows:

Day

Stock price

Day 1

50.50

Day 2

50.45

Day 3

50.60

Day 4

50.05

Day 5

50.80

In this example, the moving average of the stock price would be:

MA = (50.50+50.45+50.60+50.05+50.80)/5

MA = 252.4/5 = 50.48

Hence, the moving average of the stock price is 50.48.

After another day of trading, the latest closing price is incorporated into the calculation while the first price point (50.50 in this example) would be eliminated.

Types of moving average

There are three types of moving averages

Simple moving average (SMA): The above calculation is an example of an SMA. It gives equal weight to all the data points. Remember that the longer the SMA, the slower it reacts to the latest price movements.

Weighted moving average (WMA): In a WMA, the latest data points are given higher weights. This is to reflect the most recent changes in the stock price movement. The weights decrease consistently for each time period.

Exponential moving average (EMA): An EMA also assigns higher weights to new data points in the calculation. However, it differs from WMA in the weights assigned. Here, the weights change exponentially from one price point to the next. As a result, the average is closer to the current price compared to the SMA.

Another important aspect of moving averages is the time period used. It varies based on the type of trend the trader is trying to analyse.

Generally, the time periods used are as follows:

What are moving averages

It is important to know which type of MA to use for which period. Generally ,EMAs are used for short-term trends to incorporate the high price changes in the small time span. SMA is used more often to understand long-term trends.

Conclusion

Moving averages help traders to identify trends more easily because they smooth out the prices over a specific time period. However, it is important to remember that moving averages are based on historical data.